3 Accrual Accounting & Income

Transcription

1 29366_10_ch3_p /12/07 5:50 PM Page Accrual Accounting & Income SPOTLIGHT STARBUCKS CORPORATION Starbucks has changed coffee from a breakfast drink to an experience. The corporation began in Seattle, Washington, in 1985 and now has over 10,000 locations in the United States alone, with almost 2,000 more abroad. As you can see from Starbucks income statement, the company sold almost $8 billion of coffee and related products during the 2006 fiscal year. How does Starbucks know whether these revenues translated into profit? The income statement reports net income of $564 million. That s a lot of coffee!

2 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Resources for This Chapter In This Instructor s Manual: Chapter Overview and Objectives Lecture Outline Author s Choice (end of chapter selections) Assignment Grid 10 Minute Quiz Additional Materials: Solutions Manual (on Instructor Resource CD) PowerPoint Presentation (on Instructor Resource CD) Test Item File (on Instructor Resource CD) Runners Corp. Practice Set (on Instructor Resource CD) General Ledger Software (link on Instructor Resource CD) MyAccounting Lab (link on Instructor Resource CD) Online Materials: See This material includes Continuing Problems that help students use accounting principles in real world situations as well as additional Assessment Problems that test their knowledge. Revenues: Starbucks Corporation Income Statement (Adapted) Year Ended September 30, 2006 Net operating revenues... Other income... Total net revenues... Expenses: Cost of sales (cost of goods sold)... Store operating expenses... Other operating expenses... Depreciation and amortization expenses... General and administrative expenses... Total operating expenses... Income before income tax... Income tax expense... Net income... This chapter completes our coverage of the accounting cycle. It gives the basics of what you need before tackling individual topics such as receivables, inventory, and cash flows. LEARNING OBJECTIVES 1 Relate accrual accounting and cash flows 2 Apply the revenue and matching principles 3 Adjust the accounts 4 Prepare the financial statements 5 Close the books 6 Use 2 new ratios to evaluate a business Millions $7, ,876 3,179 2, , $ 564 For more practice and review of accounting cycle concepts, use ACT, the accounting Cycle Tutorial, online at Margin logos like this one, directing you to the appropriate ACT section and material, appear throughout Chapters 1, 2, and 3. When you enter the tutorial, you ll find three buttons on the opening page of each chapter module. Here s what the buttons mean: Tutorial gives you a review of the major concepts, Application gives you practice exercises, and Glossary reviews important terms.

3 29366_10_ch3_p /12/07 5:50 PM Page 127 Accrual Accounting Versus Cash-Basis Accounting 127 ACCRUAL ACCOUNTING VERSUS CASH-BASIS ACCOUNTING Managers want to earn a profit. Investors search for companies whose stock prices will increase. Banks seek borrowers who ll pay their debts. Accounting provides the information these people use for decision making. Accounting can be based on either the accrual basis, or the cash basis Accrual accounting records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction even if it receives or pays no cash. Cash-basis accounting records only cash transactions cash receipts and cash payments. Cash receipts are treated as revenues, and cash payments are handled as expenses. Generally accepted accounting principles (GAAP) require accrual accounting. The business records revenues as the revenues are earned and expenses as the expenses are incurred not necessarily when cash changes hands. Consider a sale on account. Which transaction increases your wealth making an $800 sale on account, or collecting the $800 cash? Making the sale increases your wealth by $300 because you gave up inventory that cost you $500 and you got a receivable worth $800. Collecting cash later merely swaps your $800 receivable for $800 cash no gain on this transaction. Making the sale not collecting the cash increases your wealth. The basic defect of cash-basis accounting is that the cash basis ignores important information. That makes the financial statements incomplete. The result? People using the statements make bad decisions. Suppose your business makes a sale on account. The cash basis does not record the sale because you received no cash. You may be thinking, Let s wait until we collect cash and then record the sale. After all, we pay the bills with cash, so ignore transactions that don t affect cash. What s wrong with this argument? There are 2 defects one on the balance sheet and the other on the income statement. Balance-Sheet Defect. If we fail to record a sale on account, the balance sheet reports no account receivable. Why is this so bad? The receivable is a real asset, and it should appear on the balance sheet. Without this information, your assets are understated as shown on the balance sheet. Income-Statement Defect. A sale on account provides revenue that increases the company s wealth. Ignoring the sale understates your revenue and net income on the income statement. The take-away lessons from this discussion are: Watch out for companies that use the cash basis of accounting. Their financial statements omit important information. All but the smallest businesses use the accrual basis of accounting.

4 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income OBJECTIVE 1Relate accrual accounting and cash flows Accrual Accounting and Cash Flows Accrual accounting is more complex and more complete than cash-basis accounting. Accrual accounting records cash transactions, such as Collecting cash from customers Borrowing money Receiving cash from interest earned Paying off loans Paying salaries, rent, and other Issuing stock expenses Accrual accounting also records noncash transactions, such as Sales on account Depreciation expense Purchases of inventory on account Usage of prepaid rent, insurance, Accrual of expenses incurred but and supplies not yet paid Earning of revenue when cash was collected in advance Accrual accounting is based on a framework of concepts and principles. We turn now to the time-period concept, the revenue principle, and the matching principle. The Time-Period Concept The only way for a business to know for certain how well it performed is to shut down, sell the assets, pay the liabilities, and return any leftover cash to the owners. This process, called liquidation, means going out of business. Ongoing companies can t wait until they go out of business to measure income! Instead, they need regular progress reports. Accountants, therefore, prepare financial statements for specific periods. The time-period concept ensures that accounting information is reported at regular intervals. The basic accounting period is 1 year, and virtually all businesses prepare annual financial statements. Around 60% of large companies including Amazon.com, ebay, and YUM! Brands use the calendar year from January 1 through December 31. A fiscal year ends on a date other than December 31. Most retailers, including Wal-Mart and JCPenney, use a fiscal year that ends on January 31 because the low point in their business activity falls after Christmas. Starbucks Corporation uses a fiscal year that ends on September 30. Companies also prepare financial statements for interim periods of less than a year, such as a month, a quarter (3 months), or a semiannual period (6 months). Most of the discussions in this text are based on an annual accounting period. OBJECTIVE 2Apply the revenue and matching principles Did You Know? Revenue recognition is one of the most important concepts in accounting. Not only do you need to know WHEN to record the revenue, but you also need to know the AMOUNT to record. The Revenue Principle The revenue principle governs two things: 1. When to record revenue (make a journal entry) 2. The amount of revenue to record When should you record revenue? After it has been earned and not before. In most cases, revenue is earned when the business has delivered a good or service to a customer. It has done everything required to earn the revenue by transferring the good or service to the customer. Exhibit 3-1 shows two situations that provide guidance on when to record revenue for Starbucks Corporation. Situation 1 illustrates when not to record revenue. No transaction has occurred, so Starbucks Corporation records nothing. Situation 2 illustrates when revenue should be recorded after a transaction has occurred.

5 29366_10_ch3_p /12/07 5:50 PM Page 129 Accrual Accounting Versus Cash-Basis Accounting 129 E X H I B I T 3-1 When to Record Revenue Situation 1 Do Not Record Revenue No transaction has occurred. Situation 2 Record Revenue Starbucks sells a cup of coffee. I plan to start drinking Starbucks coffee. Customer Great! We'll welcome you as a customer. Joe Starbucks Yum! Customer Joe Starbucks I appreciate your business. Here s your coffee. The amount of revenue to record is the cash value of the goods or services transferred to the customer. Suppose that in order to promote business, Starbucks runs a promotion and sells coffee for the discount price of $2 per cup. Ordinarily Starbucks would charge $4 for this coffee. How much revenue should Starbucks record? The answer is $2 the cash value of the transaction. The amount of the sale, $2, is the amount of revenue earned not the regular price of $4. The Matching Principle The matching principle is the basis for recording expenses. Expenses are the costs of assets used up, and of liabilities created, in the earning of revenue. Expenses have no future benefit to the company. The matching principle includes two steps: 1. Identify all the expenses incurred during the accounting period. 2. Measure the expenses, and match expenses against the revenues earned. To match expenses against revenues means to subtract expenses from revenues to compute net income or net loss. Exhibit 3-2 illustrates the matching principle. E X H I B I T 3-2 The Matching Principle a. Net income Match the expense of a period against the revenue earned during the period. b. Net loss $200 $1,000 $800 $700 $800 ($100) Revenue Expense = Net Income OR Revenue Expense = (Net Loss)

6 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Some expenses are paid in cash. Other expenses arise from using up an asset such as supplies. Still other expenses occur when a company creates a liability. For example, Starbucks salary expense occurs when employees work for the company. Starbucks may pay the salary expense immediately, or Starbucks may record a liability for the salary to be paid later. In either case, Starbucks has salary expense. The critical event for recording an expense is the employees working for the company, not the payment of cash. STOP & think A customer pays Starbucks $100 on March 15 for coffee to be served at a party in April. Has Starbucks earned revenue on March 15? When will Starbucks earn the revenue? 2. Starbucks pays $4,500 on July 1 for store rent for the next 3 months. Has Starbucks incurred an expense on July 1? Answers: 1. No. Starbucks has received the cash but will not deliver the coffee until later. Starbucks earns the revenue when it gives the goods to the customer. 2. No. Starbucks has paid cash for rent in advance. There is no expense. This prepaid rent is an asset because Starbucks has the use of a store location in the future. Ethical Issues in Accrual Accounting Accrual accounting provides some ethical challenges that cash accounting avoids. For example, suppose that in 2008, Starbucks Corporation prepays a $3 million advertising campaign to be conducted by a large advertising agency. The advertisements are scheduled to run during December, January, and February. In this case, Starbucks is buying an asset, a prepaid expense. Suppose Starbucks pays for the advertisements on December 1 and the ads start running immediately. Starbucks should record one-third of the expense ($1 million) during the year ended December 31, 2008, and two-thirds ($2 million) during Suppose 2008 is a great year for Starbucks net income is better than expected. Starbucks top managers believe that 2009 will not be as profitable. In this case, the company has a strong incentive to expense the full $3 million during 2008 in order to report all the advertising expense in the 2008 income statement. This unethical action would keep $2 million of advertising expense off the 2009 income statement and make 2009 s net income look better. OBJECTIVE 3Adjust the accounts UPDATING THE ACCOUNTS: THE ADJUSTING PROCESS At the end of the period, the business reports its financial statements. This process begins with the trial balance introduced in Chapter 2. We refer to this trial balance as unadjusted because the accounts are not yet ready for the financial statements. In most cases the simple label Trial Balance means unadjusted. Which Accounts Need to Be Updated (Adjusted)? The stockholders need to know how well Genie Car Wash is performing. The financial statements report this information, and all accounts must be up-to-date. That

7 29366_10_ch3_p /12/07 5:50 PM Page 131 Updating the Accounts: The Adjusting Process 131 means some accounts must be adjusted. Exhibit 3-3 gives the trial balance of Genie Car Wash, Inc., at June 30, 20X9. This trial balance is unadjusted. That means it s not completely up-to-date. It s not quite ready for preparing the financial statements for presentation to the public. E X H I B I T 3-3 Unadjusted Trial Balance Genie Car Wash, Inc. Unadjusted Trial Balance June 30, 20X9 Cash... Accounts receivable... Supplies... Prepaid rent... Equipment... Accounts payable... Unearned service revenue... Common stock... Retained earnings... Dividends... Service revenue... Salary expense... Utilities expense... Total... $24,800 2, ,000 24,000 3, $59,300 $13, ,000 18,800 7,000 $59,300 Teaching Tip Emphasize that adjusting entries are just another kind of journal entry and the same rules of debits=credits apply. Point out which types of accounts typically need adjusting and stress that most companies adjust these accounts as part of the normal process of accounting each period. Cash, Equipment, Accounts Payable, Common Stock, and Dividends are up-todate and need no adjustment at the end of the period. Why? Because the day-to-day transactions provide all the data for these accounts. Accounts Receivable, Supplies, Prepaid Rent, and the other accounts are another story. These accounts are not yet up-to-date on June 30. Why? Because certain transactions have not yet been recorded. Consider Supplies. During June, Genie Car Wash used cleaning supplies to wash cars. But Genie didn t make a journal entry for supplies used every time it washed a car. That would waste time and money. Instead, Genie waits until the end of the period and then records the supplies used up during the entire month. The cost of supplies used up is an expense. An adjusting entry at the end of June updates both Supplies (an asset) and Supplies Expense. We must adjust all accounts whose balances are not yet up-to-date. Categories of Adjusting Entries Accounting adjustments fall into three basic categories: deferrals, depreciation, and accruals. Deferrals. A deferral is an adjustment for an item that the business paid or received cash in advance. Starbucks purchases supplies for use in its operations. During the period, some supplies (assets) are used up and become expenses. At the end of the period, an adjustment is needed to decrease the Supplies account for the supplies used up. This is Supplies Expense. Prepaid rent, prepaid insurance, and all other prepaid expenses require deferral adjustments.

8 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Teaching Tip Many students have a hard time grasping the concept of Unearned revenue versus Earned revenue. Explain that the entry is required to record the amount of revenue that was earned during the specific period. As time passes, the unearned revenue account becomes zero, and the revenue account will now show all revenue as being earned. There are also deferral adjustments for liabilities. Companies such as Starbucks may collect cash from a grocery-store chain in advance of earning the revenue. When Starbucks receives cash up front, Starbucks has a liability to provide coffee for the customer. This liability is called Unearned Sales Revenue. Then, when Starbucks delivers the goods to the customer, it earns Sales Revenue. This earning process requires an adjustment at the end of the period. The adjustment decreases the liability and increases the revenue for the revenue earned. Publishers such as Time, Inc., and your cell-phone company collect cash in advance. They too must make adjusting entries for revenues earned later. Depreciation. Depreciation allocates the cost of a plant asset to expense over the asset s useful life. Depreciation is the most common long-term deferral. Starbucks buys buildings and equipment. As Starbucks uses the assets, it records depreciation for wear-and-tear and obsolescence. The accounting adjustment records Depreciation Expense and decreases the asset s book value over its life. The process is identical to a deferral-type adjustment; the only difference is the type of asset involved. Accruals. An accrual is the opposite of a deferral. For an accrued expense, Starbucks records the expense before paying cash. For an accrued revenue, Starbucks records the revenue before collecting cash. Salary Expense can create an accrual adjustment. As employees work for Starbucks Corporation, the company s salary expense accrues with the passage of time. At September 30, 2006, Starbucks owed employees some salaries to be paid after year end. At September 30, Starbucks recorded Salary Expense and Salary Payable for the amount owed. Other examples of expense accruals include interest expense and income tax expense. An accrued revenue is a revenue that the business has earned and will collect next year. At year end Starbucks must accrue the revenue. The adjustment debits a receivable and credits a revenue. For example, accrual of interest revenue debits Interest Receivable and credits Interest Revenue. Let s see how the adjusting process actually works for Genie Car Wash at June 30. We start with prepaid expenses. Prepaid Expenses A prepaid expense is an expense paid in advance. Therefore, prepaid expenses are assets because they provide a future benefit for the owner. Let s do the adjustments for prepaid rent and supplies. Prepaid Rent. Companies pay rent in advance. This prepayment creates an asset for the renter, who can then use the rented item in the future. Suppose Genie Car Wash prepays 3 months store rent ($3,000) on June 1. The entry for the prepayment of 3 months rent debits Prepaid Rent as follows: June 1 Prepaid Rent ($1,000 3) Cash 3,000 3,000 Paid 3 months rent in advance. The accounting equation shows that one asset increases and another decreases. Total assets are unchanged.

9 29366_10_ch3_p /12/07 5:50 PM Page 133 Updating the Accounts: The Adjusting Process 133 Assets = Liabilities + Stockholders Equity 3,000 = ,000 After posting, the Prepaid Rent account appears as follows: Prepaid Rent June 1 3,000 Throughout June, the Prepaid Rent account carries this beginning balance, as shown in Exhibit 3-3 (p. 131). The adjustment transfers $1,000 from Prepaid Rent to Rent Expense as follows:* Adjusting entry a June 30 Rent Expense ($3,000 1/3) Prepaid Rent To record rent expense. 1,000 1,000 Both assets and stockholders equity decrease. Assets = Liabilities Stockholders + Equity Expenses 1,000 = 0 1,000 After posting, Prepaid Rent and Rent Expense appear as follows: Prepaid Rent Rent Expense June 1 3,000 2,000 June 30 1,000 June 30 1,000 1,000 This expense illustrates the matching principle. We record an expense in order to measure net income. *See Exhibit 3-8, page 143, for a summary of adjustments a g.

10 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Supplies. Supplies are another type of prepaid expense. On June 2, Genie Car Wash paid cash of $700 for cleaning supplies: June 2 Supplies Cash Paid cash for supplies Assets = Liabilities + Stockholders Equity 700 = The cost of the supplies Genie used is supplies expense. To measure June s supplies expense, the business counts the supplies on hand at the end of the month. The count shows that $400 of supplies remain. Subtracting the $400 of supplies on hand from the supplies available ($700) measures supplies expense for the month ($300), as follows: Asset Available During the Period Asset on Hand at the End of the Period = Asset Used (Expense) During the Period $700 $400 = $300 The June 30 adjusting entry debits the expense and credits the asset, as follows: Adjusting entry b June 30 Supplies Expense ($700 $400) Supplies To record supplies expense Assets = Liabilities Stockholders + Equity Expenses 300 = After posting, the Supplies and Supplies Expense accounts appear as follows. The adjustment is highlighted for emphasis. Supplies Supplies Expense June June June At the start of July, Supplies has this $400 balance, and the adjustment process is repeated each month.

11 29366_10_ch3_p /12/07 5:50 PM Page 135 Updating the Accounts: The Adjusting Process 135 STOP & think... At the beginning of the month, supplies were $5,000. During the month, $7,000 of supplies were purchased. At month s end, $3,000 of supplies are still on hand. What are the adjusting entry ending balance in the Supplies account? Answer: Supplies Expense ($5,000 + $7,000 $3,000) Supplies 9,000 9,000 Ending balance of supplies = $3,000 (the supplies still on hand) Depreciation of Plant Assets Plant assets are long-lived tangible assets, such as land, buildings, furniture, and equipment. All plant assets but land decline in usefulness, and this decline is an expense. Accountants spread the cost of each plant asset, except land, over its useful life. Depreciation is the process of allocating cost to expense for a long-term plant asset. To illustrate depreciation, consider Genie Car Wash. Suppose that on June 2 Genie purchased car-washing equipment on account for $24,000: June 3 Equipment Accounts Payable 24,000 24,000 Purchased equipment on account. Assets = Liabilities + Stockholders Equity 24,000 = 24, After posting, the Equipment account appears as follows: Equipment June 3 24,000 Genie records an asset when it purchases equipment. Then, as the asset is used, a portion of the asset s cost is transferred to Depreciation Expense. Accounting matches the expense against revenue this is the matching principle. Computerized systems program the depreciation for automatic entry each period.

12 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Genie s equipment will remain useful for 5 years and then be worthless. One way to compute the amount of depreciation for each year is to divide the cost of the asset ($24,000 in our example) by its expected useful life (5 years). This procedure called the straight-line depreciation method gives annual depreciation of $4,800. The depreciation amount is an estimate. (Chapter 7 covers plant assets and depreciation in more detail.) Annual Depreciation = $24,000/5 years = $4,800 per year Depreciation for June is $400. Monthly Depreciation = $4,800/12 months = $400 per month The Accumulated Depreciation Account. Depreciation expense for June is recorded as follows: Adjusting entry c June 30 Depreciation Expense Equipment Accumulated Depreciation Equipment To record depreciation Total assets decrease by the amount of the expense: Assets = Liabilities Stockholders + Equity Expenses 400 = The Accumulated Depreciation account, (not Equipment) is credited to preserve the original cost of the asset in the Equipment account. Managers can then refer to the Equipment account if they ever need to know how much the asset cost. The Accumulated Depreciation account shows the sum of all depreciation expense from using the asset. Therefore, the balance in the Accumulated Depreciation account increases over the asset s life. Accumulated Depreciation is a contra asset account an asset account with a normal credit balance. A contra account has two distinguishing characteristics: 1. It always has a companion account. 2. Its normal balance is opposite that of the companion account. In this case, Accumulated Depreciation is the contra account to Equipment, so Accumulated Depreciation appears directly after Equipment on the balance sheet. A business carries an accumulated depreciation account for each depreciable asset, for example, Accumulated Depreciation Building and Accumulated Depreciation Equipment.

13 29366_10_ch3_p /12/07 5:50 PM Page 137 Updating the Accounts: The Adjusting Process 137 After posting, the plant asset accounts of Genie Car Wash are as follows with the adjustment highlighted: Equipment Accumulated Depreciation Equipment Depreciation Expense Equipment June 3 24,000 24,000 June June Book Value. The net amount of a plant asset (cost minus accumulated depreciation) is called that asset s book value, or carrying amount. Exhibit 3-4 shows how Genie would report the book value of its equipment and building at June 30 (the building data are assumed for this illustration). E X H I B I T 3-4 Plant Assets on the Balance Sheet of Genie Car Wash Genie Car Wash Plant Assets at June 30 Equipment... Less: Accumulated Depreciation... $24,000 (400) $23,600 Building... Less: Accumulated Depreciation... Book value of plant assets... $50,000 (200) 49,800 $73,400 At June 30, the book value of equipment is $23,600; the book value of the building is $49,800. STOP & think... What will be the book value of Genie s equipment at the end of July? Answer: $24,000 $400 $400 = $23,200. Exhibit 3-5 shows how Starbucks Corporation reports property, plant, and equipment in its annual report. Lines 1 to 6 list specific assets and their cost. Line 7 shows the cost of all Starbucks plant assets. Line 8 gives the amount of accumulated depreciation, and line 9 shows the assets book value of $2,288 million.

14 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income E X H I B I T 3-5 Starbucks Corporation s Reporting of Property, Plant, and Equipment (Adapted, in millions) 1 Land... $ 32 2 Buildings Leasehold improvements... 2,437 4 Store equipment Roasting equipment Furniture, fixtures, and other Property, plant, and equipment, at cost... 4,258 8 Less: Accumulated depreciation... (1,970) 9 Property, plant, and equipment, net... $2,288 Accrued Expenses Businesses incur expenses before they pay cash. Consider an employee s salary. Starbucks expense and payable grow as the employee works, so the liability is said to accrue. Another example is interest expense on a note payable. Interest accrues as the clock ticks. The term accrued expense refers to a liability that arises from an expense that has not yet been paid. Companies don t record accrued expenses daily or weekly. Instead, they wait until the end of the period and use an adjusting entry to update each expense (and related liability) for the financial statements. Let s look at salary expense. Most companies pay their employees at set times. Suppose Genie Car Wash pays its employee a monthly salary of $1,800, half on the 15th and half on the last day of the month. The following calendar for June has the paydays circled: June Sun. Mon. Tue. Wed. Thur. Fri. Sat Assume that if a payday falls on a Sunday, Genie pays the employee on the following Monday. During June, Genie paid its employees the first half-month salary of $900 and made the following entry: June 15 Salary Expense Cash To pay salary Assets = Liabilities Stockholders + Equity Expenses 900 = 0 900

15 29366_10_ch3_p /12/07 5:50 PM Page 139 Updating the Accounts: The Adjusting Process 139 After posting, the Salary Expense account is Salary Expense June The trial balance at June 30 (Exhibit 3-3, p. 131) includes Salary Expense with its debit balance of $900. Because June 30, the second payday of the month, falls on a Sunday, the second half-month amount of $900 will be paid on Monday, July 1. At June 30, therefore, Genie adjusts for additional salary expense and salary payable of $900 as follows: Adjusting entry d June 30 Salary Expense Salary Payable To accrue salary expense An accrued expense increases liabilities and decreases stockholders equity: Assets = Liabilities Stockholders + Equity Expenses 0 = After posting, the Salary Payable and Salary Expense accounts appear as follows (adjustment highlighted): Salary Payable June June 15 June 30 Salary Expense ,800 The accounts now hold all of June s salary information. Salary Expense has a full month s salary, and Salary Payable shows the amount owed at June 30. All accrued expenses are recorded this way debit the expense and credit the liability. Computerized systems contain a payroll module. Accrued salaries can be automatically journalized and posted at the end of each period. Accrued Revenues Businesses often earn revenue before they receive the cash. A revenue that has been earned but not yet collected is called an accrued revenue.

16 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Assume that FedEx hires Genie on June 15 to wash FedEx delivery trucks each month. Suppose FedEx will pay Genie $600 monthly, with the first payment on July 15. During June, Genie will earn half a month s fee, $300, for work done June 15 through June 30. On June 30, Genie makes the following adjusting entry: Adjusting entry e June 30 Accounts Receivable ($600 1/2) Service Revenue To accrue service revenue. Revenue increases both total assets and stockholders equity: Assets = Liabilities + Stockholders Equity + Revenues 300 = Recall that Accounts Receivable has an unadjusted balance of $2,200, and Service Revenue s unadjusted balance is $7,000 (Exhibit 3-3, p. 131). This June 30 adjusting entry has the following effects (adjustment highlighted): Accounts Receivable Service Revenue June 30 2, ,500 June 30 7, ,300 All accrued revenues are accounted for similarly debit a receivable and credit a revenue. STOP & think... Suppose Genie Car Wash holds a note receivable as an investment. At the end of June, $100 of interest revenue has been earned. Journalize the accrued revenue adjustment at June 30. Answer: June 30 Interest Receivable Interest Revenue To accrue interest revenue.

17 29366_10_ch3_p /12/07 5:50 PM Page 141 Updating the Accounts: The Adjusting Process 141 Unearned Revenues Some businesses collect cash from customers before earning the revenue. This creates a liability called unearned revenue. Only when the job is completed does the business earn the revenue. Suppose Home Depot engages Genie Car Wash to wash Home Depot trucks, agreeing to pay Genie $400 monthly, beginning immediately. If Genie collects the first amount on June 15, then Genie records this transaction as follows: June 15 Cash Unearned Service Revenue Received cash for revenue in advance. Assets = Liabilities + Stockholders Equity 400 = After posting, the liability account appears as follows: Unearned Service Revenue June Unearned Service Revenue is a liability because Genie is obligated to perform services for Home Depot. The June 30 unadjusted trial balance (Exhibit 3-3, p. 131) lists Unearned Service Revenue with a $400 credit balance. During the last 15 days of the month, Genie will earn one-half of the $400, or $200. On June 30, Genie makes the following adjustment: Adjusting entry f June 30 Unearned Service Revenue ($400 1/2) Service Revenue To record unearned service revenue that has been earned. Assets = Liabilities + Stockholders Equity + Revenues 0 =

18 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income This adjusting entry shifts $200 of the total amount received ($400) from liability to revenue. After posting, Unearned Service Revenue is reduced to $200, and Service Revenue is increased by $200, as follows (adjustment highlighted): Unearned Service Revenue June June Service Revenue June 30 June 30 7, ,500 All revenues collected in advance are accounted for this way. An unearned revenue is a liability, not a revenue. One company s prepaid expense is the other company s unearned revenue. For example, Home Depot s prepaid expense is Genie Car Wash s liability for unearned revenue. Exhibit 3-6 diagrams the distinctive timing of prepaids and accruals. Study prepaid expenses all the way across. Then study unearned revenues across, and so on. E X H I B I T 3-6 Prepaid and Accrual Adjustments PREPAIDS Cash First First Later Prepaid Pay cash and record an asset: Record an expense and decrease the asset: expenses Prepaid Expense... XXX Expense... XXX Cash... XXX Prepaid Expense... XXX Unearned Receive cash and record Record revenue and decrease revenues unearned revenue: unearned revenue: Cash... XXX Unearned Revenue... XXX Unearned Revenue XXX Revenue... XXX ACCRUALS Cash Later First Later Accrued Accrue expense and a payable: Pay cash and decrease the payable: expenses Expense... XXX Payable... XXX Payable... XXX Cash... XXX Accrued Accrue revenue and a receivable: Receive cash and decrease the receivable: revenues Receivable... XXX Cash... XXX Revenue... XXX Receivable... XXX The authors thank Professors Darrel Davis and Alfonso Oddo for suggesting this exhibit.

19 29366_10_ch3_p /12/07 5:50 PM Page 143 Summary of the Adjusting Process Two purposes of the adjusting process are to Measure income Update the balance sheet Therefore, every adjusting entry affects at least one Revenue or expense to measure Asset or liability to update the income balance sheet Exhibit 3-7 summarizes the standard adjustments. Updating the Accounts: The Adjusting Process 143 E X H I B I T 3-7 Summary of Adjusting Entries Type of Account Category of Adjusting Entry Debit Credit Prepaid expense... Expense Asset Depreciation... Expense Contra asset Accrued expense... Expense Liability Accrued revenue... Asset Revenue Unearned revenue... Liability Revenue Adapted from material provided by Beverly Terry. Exhibit 3-8 summarizes the adjustments of Genie Car Wash, Inc., at June 30 the adjusting entries we ve examined over the past few pages. E X H I B I T 3-8 The Adjusting Process of Genie Car Wash, Inc. PANEL A Information for Adjustments at June 30, 20X9 PANEL B Adjusting Entries (a) Prepaid rent expired, $1,000. (a) Rent Expense... 1,000 Prepaid Rent... 1,000 To record rent expense. (b) Supplies used, $300. (b) Supplies Expense Supplies To record supplies used. (c) Depreciation on equipment, $400. (c) Depreciation Expense Equipment Accumulated Depreciation Equipment 400 To record depreciation. (d) Accrued salary expense, $900. (d) Salary Expense Salary Payable To accrue salary expense. (e) Accrued service revenue, $300. (e) Accounts Receivable Service Revenue To accrue service revenue. (f) Amount of unearned service (f) Unearned Service Revenue revenue that has been earned, $200. Service Revenue To record unearned revenue that has been earned. (g) Accrued income tax expense, $600. (g) Income Tax Expense Income Tax Payable To accrue income tax expense.

20 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income PANEL C Ledger Accounts Assets 24,800 Cash Accounts Receivable (e) 2, ,500 Supplies (b) 300 Prepaid Rent 3,000 2,000 Equipment 24,000 (a) 1,000 Accumulated Depreciation Equipment (c) Liabilities Accounts Payable 13,100 Salary Payable (d) Unearned Service Revenue (f) Income Tax Payable (g) Common Stock Revenue Stockholders Equity 20,000 Retained Earnings Dividends 3,200 18,800 Service Revenue (e) (f) 7, ,500 (a) (d) (b) Expenses Rent Expense 1,000 1,000 Salary Expense ,800 Supplies Expense Depreciation Expense Equipment (c) Utilities Expense 500 Income Tax Expense (g) Panel A repeats the data for each adjustment. Panel B gives the adjusting entries. Panel C shows the accounts after posting the adjusting entries. The adjustments are keyed by letter. Exhibit 3-8 includes an additional adjusting entry that we have not yet discussed the accrual of income tax expense. Like individual taxpayers, corporations are subject to income tax. They typically accrue income tax expense and the related income tax payable as the final adjusting entry of the period. Genie Car Wash accrues income tax expense with adjusting entry g, as follows: Adjusting entry g June 30 Income Tax Expense Income Tax Payable To accrue income tax expense The income tax accrual follows the pattern for accrued expenses.

21 29366_10_ch3_p /12/07 5:50 PM Page 145 Updating the Accounts: The Adjusting Process 145 The Adjusted Trial Balance This chapter began with the unadjusted trial balance (see Exhibit 3-3, p. 131). After the adjustments are journalized and posted, the accounts appear as shown in Exhibit 3-8, Panel C. A useful step in preparing the financial statements is to list the accounts, along with their adjusted balances, on an adjusted trial balance. This document lists all the accounts and their final balances in a single place. Exhibit 3-9 shows the adjusted trial balance of Genie Car Wash. Teaching Tip Make sure that the students are transferring numbers correctly from the ledger to the unadjusted trial balance. Also stress that adjustments are not always a matter of simply adding debits to debits and credits to credits. Many times, both a debit and credit are affected in the same adjusting entry. E X H I B I T 3-9 Adjusted Trial Balance Genie Car Wash, Inc. Preparation of Adjusted Trial Balance June 30, 20X9 Trial Balance Adjustments Adjusted Trial Balance Account Title Debit Credit Debit Credit Debit Credit Cash Accounts receivable Supplies Prepaid rent Equipment Accumulated depreciation equipment Accounts payable Salary payable Unearned service revenue Income tax payable Common stock Retained earnings Dividends Service revenue Rent expense Salary expense Supplies expense Depreciation expense Utilities expense Income tax expense 24,800 2, ,000 24,000 3, ,300 13, ,000 18,800 7,000 59,300 (e) (f) (a) (d) (b) (c) (g) , ,700 (b) (a) (c) (d) (g) (e) (f) 300 1, ,700 24,800 2, ,000 24,000 3,200 1,000 1, , , ,000 18,800 7,500 61,500 Balance Sheet (Exhibit 3-12) Statement of Retained Earnings (Exhibit 3-11) Income Statement (Exhibit 3-10) Note how clearly the adjusted trial balance presents the data. The Account Title and the Trial Balance data come from the trial balance. The two Adjustments columns summarize the adjusting entries. The Adjusted Trial Balance columns then give the final account balances. Each adjusted amount in Exhibit 3-9 is the unadjusted balance plus or minus the adjustments. For example, Accounts Receivable starts with a Accounting Cycle Tutorial Glossary

22 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income balance of $2,200. Add the $300 debit adjustment to get Accounts Receivable s ending balance of $2,500. Spreadsheets are designed for this type of analysis. OBJECTIVE 4Prepare the financial statements Something to Consider Have your students discuss why the financial statements must be prepared in the order of income statement, retained earnings statement, and balance sheet. Teaching Tip Stress that the income statement and the statement of retained earnings are for a specific period of time, but that the balance sheet is an indication of financial position on a specified date. PREPARING THE FINANCIAL STATEMENTS The June financial statements of Genie Car Wash can be prepared from the adjusted trial balance. At the far right, Exhibit 3-9 shows how the accounts are distributed to the financial statements. The income statement (Exhibit 3-10) lists the revenue and expense accounts. The statement of retained earnings (Exhibit 3-11) shows the changes in retained earnings. The balance sheet (Exhibit 3-12) reports assets, liabilities, and stockholders equity. The arrows in Exhibits 3-10, 3-11, and 3-12 show the flow of data from one statement to the next. Why is the income statement prepared first and the balance sheet last? 1. The income statement reports net income or net loss, the result of revenues minus expenses. Revenues and expenses affect stockholders equity, so net income is then transferred to retained earnings. The first arrow tracks net income. 2. Retained Earnings is the final balancing element of the balance sheet. To solidify your understanding, trace the $18,500 retained earnings figure from Exhibit 3-11 to Exhibit Arrow 2 tracks retained earnings.

23 29366_10_ch3_p /12/07 5:50 PM Page 147 Preparing the Financial Statements 147 E X H I B I T 3-10 Income Statement Genie Car Wash, Inc. Income Statement Month Ended June 30, 20X9 Revenues: Service revenue... Expenses: Salary expense... Rent expense... Utilities expense... Depreciation expense... Supplies expense... Income before tax... Income tax expense... Net income... $1,800 1, $7,500 4,000 3, $2,900 E X H I B I T 3-11 Statement of Retained Earnings Genie Car Wash, Inc. Statement of Retained Earnings Month Ended June 30, 20X9 1 Retained earnings, May 31, 20X9... Add: Net income... Less: Dividends... Retained earnings, June 30, 20X9... $18,800 2,900 21,700 (3,200) $18,500 E X H I B I T 3-12 Balance Sheet Assets Genie Car Wash, Inc. Balance Sheet June 30, 20X9 Liabilities 2 Cash... $24,800 Accounts payable... $13,100 Accounts receivable... 2,500 Salary payable Supplies Unearned service revenue Prepaid rent... 2,000 Income tax payable Equipment... $24,000 Total liabilities... 14,800 Less: Accumulated depreciation... (400) 23,600 Stockholders Equity Common stock... 20,000 Retained earnings... 18,500 Total stockholders equity... 38,500 Total liabilities and Total assets... $53,300 stockholders equity... $53,300

24 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income MID-CHAPTER SUMMARY PROBLEM The trial balance of Goldsmith Company shown below pertains to December 31, 20X5, which is the end of its year-long accounting period. Data needed for the adjusting entries include the following: a. Supplies on hand at year end, $2,000. b. Depreciation on furniture and fixtures, $20,000. c. Depreciation on building, $10,000. d. Salaries owed but not yet paid, $5,000. e. Accrued service revenue, $12,000. f. Of the $45,000 balance of unearned service revenue, $32,000 was earned during the year. g. Accrued income tax expense, $35,000. Required 1. Open the ledger accounts with their unadjusted balances. Show dollar amounts in thousands, as shown for Accounts Receivable: Accounts Receivable Journalize the Goldsmith Company adjusting entries at December 31, 20X5. Key entries by letter, as in Exhibit 3-8, page Post the adjusting entries. 4. Prepare an adjusted trial balance, as shown in Exhibit 3-9, page Prepare the income statement, the statement of retained earnings, and the balance sheet. (At this stage, it is not necessary to classify assets or liabilities as current or long term.) Draw arrows linking these three financial statements. Goldsmith Company Trial Balance December 31, 20X5 Cash... Accounts receivable... Supplies... Furniture and fixtures... Accumulated depreciation furniture and fixtures... Building... Accumulated depreciation building... Accounts payable... Salary payable... Unearned service revenue... Income tax payable... Common stock... Retained earnings... Dividends... Service revenue... Salary expense... Supplies expense... Depreciation expense furniture and fixtures... Depreciation expense building... Income tax expense... Miscellaneous expense... Total... $ 198, ,000 6, , ,000 65, ,000 13,000 $1,174,000 $ 40, , ,000 45, , , ,000 $1,174,000

25 29366_10_ch3_p /12/07 5:50 PM Page 149 Answers Requirements 1 and 3 Assets Stockholders Equity Cash Building Common Stock Expenses Salary Expense (e) Accounts Receivable Supplies 6 2 (a) Furniture and Fixtures 4 Accumulated Depreciation Building (c) Liabilities Accounts Payable Retained Earnings Dividends (d) (a) (b) Supplies Expense 4 4 Depreciation Expense Furniture and Fixtures Accumulated Depreciation Furniture and Fixtures (b) Salary Payable (d) Unearned Service Revenue (f) 32 Income Tax Payable (g) Revenues Service Revenue (e) (f) (c) (g) Depreciation Expense Building Income Tax Expense Miscellaneous Expense 13 Requirements 2 (a) Dec. 31 Supplies Expense ($6,000 $2,000) 4,000 Supplies 4,000 To record supplies used. (b) 31 Depreciation Expense Furniture and Fixtures 20,000 Accumulated Depreciation Furniture and Fixtures 20,000 To record depreciation expense on furniture and fixtures. (c) 31 Depreciation Expense Building 10,000 Accumulated Depreciation Building 10,000 To record depreciation expense on building. (d) 31 Salary Expense 5,000 Salary Payable 5,000 To accrue salary expense. (e) 31 Accounts Receivable 12,000 Service Revenue 12,000 To accrue service revenue. (f) 31 Unearned Service Revenue 32,000 Service Revenue 32,000 To record unearned service revenue that has been earned. (g) 31 Income Tax Expense 35,000 Income Tax Payable 35,000 To accrue income tax expense.

26 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Requirements 4 Goldsmith Company Preparation of Adjusted Trial Balance December 31, 20X5 Trial Balance Adjustments Adjusted Trial Balance Account Title Debit Credit Debit Credit Debit Credit Cash Accounts receivable Supplies Furniture and fixtures Accumulated depreciation furniture and fixtures Building Accumulated depreciation building Accounts payable Salary payable Unearned service revenue Income tax payable Common stock Retained earnings Dividends Service revenue Salary expense Supplies expense Depreciation expense furniture and fixtures Depreciation expense building Income tax expense Miscellaneous expense , ,174 (e) (f) (d) (a) (b) (c) (g) (a) (b) (c) (d) (g) (e) (f) , ,256

27 29366_10_ch3_p /12/07 5:50 PM Page 151 Mid-Chapter Summary Problem 151 Requirements 5 (Amounts in thousands) Revenue: Goldsmith Company Income Statement Year Ended December 31, 20X5 Service revenue... Expenses: Salary expense... Depreciation expense furniture and fixtures... Depreciation expense building... Supplies expense... Miscellaneous expense... Income before tax... Income tax expense... Net income... $ $ $ 71 Goldsmith Company Statement of Retained Earnings Year Ended December 31, 20X5 1 (Amounts in thousands) Retained earnings, December 31, 20X4... Add: Net income... Less: Dividends... Retained earnings, December 31, 20X5... $ (65) $199 Goldsmith Company Balance Sheet December 31, 20X5 (Amounts in thousands) Assets Cash... Accounts receivable... Supplies... Furniture and fixtures... Less: Accumulated depreciation... Building... Less: Accumulated depreciation... Total assets... $100 (60) $250 (140) $ $732 Liabilities Accounts payable... Salary payable... Unearned service revenue... Income tax payable... Total liabilities... Stockholders Equity Common stock... Retained earnings... Total stockholders equity... Total liabilities and stockholders equity... $ $732 2

28 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income OBJECTIVE 5Close the books Which Accounts Need to Be Closed? It is now June 30, the end of the month. Van Gray, the manager, will continue Genie Car Wash into July, August, and beyond. But wait the revenue and the expense accounts still hold amounts for June. At the end of each accounting period, it is necessary to close the books. Closing the books means to prepare the accounts for the next period s transactions. The closing entries set the revenue, expense, and dividends balances back to zero at the end of the period. The idea is the same as setting the scoreboard back to zero after a game. Closing is easily handled by computers. Recall that the income statement reports only one period s income. For example, net income for Starbucks or Genie Car Wash for 2008 relates exclusively to At each year end, Starbucks accountants close the company s revenues and expenses for that year. Temporary accounts. Because revenues and expenses relate to a limited period, they are called temporary accounts. The Dividends account is also temporary. The closing process applies only to temporary accounts (revenues, expenses, and dividends). Permanent accounts. Let s contrast the temporary accounts with the permanent accounts: assets, liabilities, and stockholders equity. The permanent accounts are not closed at the end of the period because they carry over to the next period. Consider Cash, Receivables, Equipment, Accounts Payable, Common Stock, and Retained Earnings. Their ending balances at the end of one period become the beginning balances of the next period. Closing entries transfer the revenue, expense, and dividends balances to Retained Earnings. Here are the steps to close the books of a company such as Starbucks Corporation or Genie Car Wash: 1 Debit each revenue account for the amount of its credit balance. Credit Retained Earnings for the sum of the revenues. Now the sum of the revenues is in Retained Earnings. 2 Credit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of the expenses. The sum of the expenses is now in Retained Earnings. 3 Credit the Dividends account for the amount of its debit balance. Debit Retained Earnings. This entry places the dividends amount in the debit side of Retained Earnings. Remember that dividends are not expenses. Dividends never affect net income. After closing the books, the Retained Earnings account of Genie Car Wash appears as follows (data from page 147): Retained Earnings Beginning balance 18,800 Expenses 4,600 Revenues 7,500 Dividends 3,200 Ending balance 18,500

29 29366_10_ch3_p /12/07 5:50 PM Page 153 Preparing the Financial Statements 153 Assume that Genie Car Wash closes the books at the end of June. Exhibit 3-13 presents the complete closing process for the business. Panel A gives the closing journal entries, and Panel B shows the accounts after closing. E X H I B I T 3-13 Journalizing and Posting the Closing Entries PANEL A Journalizing the Closing Entries Page 5 Closing Entries 1 June 30 Service Revenue... 7,500 Retained Earnings... 7, Retained Earnings... 4,600 Rent Expense... 1,000 Salary Expense... 1,800 Supplies Expense Depreciation Expense Utilities Expense Income Tax Expense ➂ 30 Retained Earnings... 3,200 Dividends... 3,200 PANEL B Posting to the Accounts Adj. Rent Expense 1,000 1,000 Clo. 1,000 Salary Expense Service Revenue Clo. 7,500 Adj. Adj. 7, ,500 Accounting Cycle Tutorial Adjusting & Closing the Books Adj ,800 Clo. 1, Adj. Supplies Expense Clo. 300 Depreciation Expense Adj Clo. 400 Utilities Expense Clo. Clo. Retained Earnings 4,600 3,200 Clo. 3 18,800 7,500 18,500 Dividends 3,200 Clo. 3,200 Accounting Cycle Tutorial Application Cottage Kitchen Clo. 500 Income Tax Expense Adj Clo. 600 Adj. = Amount posted from an adjusting entry Clo. = Amount posted from a closing entry = Balance As arrow 2 in Panel B shows, we can make a compound closing entry for all the expenses. Accounting Cycle Tutorial Application Cottage Kitchen 2

30 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Classifying Assets and Liabilities Based on Their Liquidity On the balance sheet, assets and liabilities are classified as current or long term to indicate their relative liquidity. Liquidity measures how quickly an item can be converted to cash. Cash is the most liquid asset. Accounts receivable are relatively liquid because cash collections usually follow quickly. Inventory is less liquid than accounts receivable because the company must first sell the goods. Equipment and buildings are even less liquid because these assets are held for use and not for sale. A balance sheet lists assets and liabilities in the order of relative liquidity. Current Assets. As we saw in Chapter 1, current assets are the most liquid assets. They will be converted to cash, sold, or consumed during the next 12 months or within the business s normal operating cycle if longer than a year. The operating cycle is the time span during which cash is paid for goods and services and these goods and services are sold to bring in cash. For most businesses, the operating cycle is a few months. Cash, Short-Term Investments, Accounts Receivable, Merchandise Inventory, and Prepaid Expenses are the current assets. Long-Term Assets. Long-term assets are all assets not classified as current assets. One category of long-term assets is plant assets, often labeled Property, Plant, and Equipment. Land, Buildings, Furniture and Fixtures, and Equipment are plant assets. Of these, Genie Car Wash has only Equipment. Long-Term Investments, Intangible Assets, and Other Assets (a catchall category for assets that are not classified more precisely) are also long-term. Current Liabilities. As we saw in Chapter 1, current liabilities are debts that must be paid within 1 year or within the entity s operating cycle if longer than a year. Accounts Payable, Notes Payable due within 1 year, Salary Payable, Unearned Revenue, Interest Payable, and Income Tax Payable are current liabilities. Bankers and other lenders are interested in the due dates of an entity s liabilities. The sooner a liability must be paid, the more pressure it creates. Therefore, the balance sheet lists liabilities in the order in which they must be paid. Balance sheets usually report two liability classifications, current liabilities and long-term liabilities. Long-Term Liabilities. All liabilities that are not current are classified as longterm liabilities. Many notes payable are long term. Some notes payable are paid in installments, with the first installment due within 1 year, the second installment due the second year, and so on. The first installment is a current liability and the remainder is long term. Let s see how Starbucks Corporation reports these asset and liability categories on its balance sheet. Reporting Assets and Liabilities: Starbucks Corporation Exhibit 3-14 shows the actual classified balance sheet of Starbucks Corporation. A classified balance sheet separates current assets from long-term assets and current liabilities from long-term liabilities. You should be familiar with most of Starbucks accounts. Study the Starbucks balance sheet all the way through line by line.

31 29366_10_ch3_p /12/07 5:50 PM Page 155 Formats for the Financial Statements 155 E X H I B I T 3-14 Classified Balance Sheet of Starbucks Corporation (Adapted, in millions) Starbucks Corporation Balance Sheet (Adapted) September 30, 2006 (millions) Assets Current assets: Cash and cash equivalents... Short-term investments... Accounts receivable... Inventories... Prepaid expenses and other current assets... Total current assets... Long-term investments... Property, plant, and equipment, net... Intangible assets... Other assets... Total assets... Liabilities and Shareholders Equity Current liabilities: Accounts payable... Accrued expenses payable... Short-term notes payable... Current portion of long-term... Unearned revenue... Total current liabilities... Long-term debt... Other long-term liabilities... Total liabilities... Shareholders equity: Common stock... Retained earnings... Other equity... Total shareholders equity... Total liabilities and shareholders equity... $ , , $4,429 $ , , , ,229 $4,429 FORMATS FOR THE FINANCIAL STATEMENTS Companies can format their financial statements in different ways. Both the balance sheet and the income statement can be formatted in two basic ways. Balance Sheet Formats The report format lists the assets at the top, followed by the liabilities and stockholders equity below. The balance sheet of Starbucks Corporation in Exhibit 3-14 illustrates the report format. The report format is more popular, with approximately 60% of large companies using it.

32 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income The account format lists the assets on the left and the liabilities and stockholders equity on the right in the same way that a T-account appears, with assets (debits) on the left and liabilities and equity (credits) on the right. Exhibit 3-12 (p. 147) shows an account-format balance sheet for Genie Car Wash. Either format is acceptable. Income Statement Formats A single-step income statement lists all the revenues together under a heading such as Revenues, or Revenues and Gains. The expenses are listed together in a single category titled Expenses, or Expenses and Losses. There is only one step, the subtraction of Expenses and Losses from the sum of Revenues and Gains, in arriving at net income. Starbucks income statement (p.126) appears in single-step format. A multi-step income statement reports a number of subtotals to highlight important relationships between revenues and expenses. Exhibit 3-15 shows Starbucks income statement in multi-step format. Gross profit, income from operations, income before tax, and net income are highlighted for emphasis. E X H I B I T Starbucks Corporation Income Statement in Multi-Step Format Starbucks Corporation Income Statement (Adapted) Year Ended September 30, 2006 Net operating revenues... Cost of sales (Cost of goods sold)... Gross profit... Store operating expenses... Other operating expenses... Depreciation and amortization expenses... General and administrative expenses... Total operating expenses... Income from operations... Other income... Income before income taxes... Income tax expense... Net income... $2, Millions $7,787 3,179 4,608 3, $ 564 In particular, income from operations ($800 million) is separated from Other income, which Starbucks did not earn by selling coffee. The other income was mainly interest revenue and other investment income. Most companies consider it important to report their operating income separately from nonoperating income such as interest and dividends. Most companies income statements do not conform to either a pure single-step format or a pure multi-step format. Business operations are too complex for all companies to conform to rigid reporting formats.

33 29366_10_ch3_p /12/07 5:50 PM Page 157 Using Accounting Ratios 157 USING ACCOUNTING RATIOS As we ve seen, accounting provides information for decision making. A bank considering lending money must predict whether the borrower can repay the loan. If the borrower already has a lot of debt, the probability of repayment may be low. If the borrower owes little, the loan may go through. To analyze a company s financial position, decision makers use ratios computed from various items in the financial statements. Let s see how this process works. Current Ratio One of the most widely used financial ratios is the current ratio, which divides total current assets by total current liabilities, taken from the balance sheet. Current ratio = Total current assets Total current liabilities For Starbucks Corporation (amounts in millions on page 155): OBJECTIVE 6Use 2 new ratios to evaluate a business Did You Know? Computing financial ratios is the best way for decision makers to assess the true financial condition of the company. As more ratios are computed, management can make better informed decisions about the company. Total current assets $1,530 Current ratio = = = 0.79 Total current liabilities $1,935 The current ratio measures the company s ability to pay current liabilities with current assets. A company prefers a high current ratio, which means that the business has plenty of current assets to pay current liabilities. An increasing current ratio from period to period indicates improvement in financial position. As a rule of thumb, a strong current ratio is 1.50, which indicates that the company has $1.50 in current assets for every $1.00 in current liabilities. A company with a current ratio of 1.50 would probably have little trouble paying its current liabilities. Most successful businesses operate with current ratios between 1.20 and A current ratio of 1.00 is considered quite low. Starbucks current ratio of 0.79 is very low and indicates a weak current position. How does Starbucks survive with so low a current ratio? The company makes most sales for cash, and it has little debt. That leads us to the next ratio. Debt Ratio A second aid to decision making is the debt ratio, which is the ratio of total liabilities to total assets: Debt ratio = Total liabilities Total assets For Starbucks (amounts in millions on page 155), Debt ratio = Total liabilities Total assets $2,200 = = 0.50 $4,429

34 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income The debt ratio indicates the proportion of a company s assets that is financed with debt. This ratio measures a business s ability to pay both current and long-term debts (total liabilities). A low debt ratio is safer than a high debt ratio. Why? Because a company with few liabilities has low required debt payments. This company is unlikely to get into financial difficulty. By contrast, a business with a high debt ratio may have trouble paying its liabilities, especially when sales are low and cash is scarce. Starbucks debt ratio of 50% (0.50) is low compared to most companies in the United States. The norm for the debt ratio ranges from 60% to 70%. Starbucks debt ratio indicates low risk for the company, and that partly offsets Starbucks risky current ratio. When a company fails to pay its debts, creditors can take the company away from its owners. Most bankruptcies result from high debt ratios. How Do Transactions Affect the Ratios? Companies such as Starbucks are keenly aware of how transactions affect their ratios. Lending agreements often require that a company s current ratio not fall below a certain level. Another loan requirement is that the company s debt ratio may not rise above a threshold, such as When a company fails to meet one of these conditions, it is said to violate its lending agreements. The penalty can be severe: The lender can require immediate payment of the loan. Starbucks has so little debt that the company is not in much danger. But many companies are. Let s use Starbucks Corporation to examine the effects of some transactions on the company s current ratio and debt ratio. As shown in the preceding section, Starbucks ratios are as follows (dollar amounts in millions): $1,530 Current ratio = $1,935 = 0.79 $2,200 Debt ratio = $4,429 = 0.50 The managers of any company would be concerned about how inventory purchases, payments on account, expense accruals, and depreciation would affect its ratios. Let s see how Starbucks would be affected by some typical transactions. For each transaction, the journal entry helps identify the effects on the company. a. Issued stock and received cash of $50 million. Journal entry: Cash Common Stock Cash, a current asset, affects both the current ratio and the debt ratio as follows: Current ratio = $1,530 + $50 = 0.82 $1,935 $2,200 Debt ratio = $4,429 + $50 = 0.49 The issuance of stock improves both ratios.

35 29366_10_ch3_p /12/07 5:50 PM Page 159 Using Accounting Ratios 159 b. Paid cash to purchase buildings for $20 million. Journal entry: Buildings Cash Cash, a current asset, decreases, but total assets stay the same. Liabilities are unchanged. Current ratio = $1,530 $20 = 0.78 $1,935 $2,200 Debt ratio = = 0.50; no change $4,429 + $20 $20 A cash purchase of a building hurts the current ratio, but doesn t affect the debt ratio. c. Made a $30 million sale on account to a grocery chain. Journal entry: Accounts Receivable Sales Revenue The increase in Accounts Receivable increases current assets and total assets, as follows: Current ratio = $1,530 + $30 = 0.81 $1,935 $2,200 Debt ratio = $4,429 + $30 = 0.49 A sale on account improves both ratios. d. Collected the account receivable, $30 million. Journal entry: Cash Accounts Receivable This transaction has no effect on total current assets, total assets, or total liabilities. Both ratios are unaffected. e. Accrued expenses at year end, $40 million. Journal entry: Expenses Expenses Payable $1,530 Current ratio = = 0.78 $1,935 + $40 $2,200 + $40 Debt ratio = = 0.51 $4,429 Most expenses hurt both ratios.

36 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income f. Recorded depreciation, $80 million. Journal entry: Depreciation Expense Accumulated Depreciation No current accounts are affected, so only the debt ratio is affected. $2,200 Current ratio = $1,530 Debt ratio = = 0.51 $1,935 = 0.79 $4,429 $80 Depreciation decreases total assets and therefore hurts the debt ratio. g. Earned interest revenue and collected cash, $40 million. Journal entry: Cash Interest Revenue Cash, a current asset, affects both the current ratio and the debt ratio as follows: $1,530 + $40 Current ratio = = 0.81 $1,935 $2,200 Debt ratio = = 0.49 $4,429 + $40 A revenue improves both ratios. Now, let s wrap up the chapter by seeing how to use the current ratio and the debt ratio for decision making. The Decision Guidelines feature offers some clues.

37 29366_10_ch3_p /12/07 5:50 PM Page 161 Decision Guidelines 161 DECISION GUIDELINES USING THE CURRENT RATIO AND THE DEBT RATIO In general, a high current ratio is preferable to a low current ratio. Increases in the current ratio improve financial position. By contrast, a low debt ratio is preferable to a high debt ratio. Improvement is indicated by a decrease in the debt ratio. No single ratio gives the whole picture about a company. Therefore, lenders and investors use many ratios to evaluate a company. Let s apply what we have learned. Suppose you are a loan officer at Bank One, and Starbucks Corporation has asked you for a $20 million loan to launch a new blend of coffee. How will you make this loan decision? The Decision Guidelines show how bankers and investors use two key ratios. USING THE CURRENT RATIO Decision How can you measure a company s ability to pay current liabilities with current assets? Who uses the current ratio for decision making? What is a good value of the current ratio? Guidelines Current ratio = Total current assets Total current liabilities Lenders and other creditors, who must predict whether a borrower can pay its current liabilities. Stockholders, who know that a company that cannot pay its debts is not a good investment because it may go bankrupt. Managers, who must have enough cash to pay the company s current liabilities. Depends on the industry: A company with strong cash flow can operate successfully with a low current ratio of, say, A company with weak cash flow needs a higher current ratio of, say, Traditionally, a current ratio of 2.00 was considered ideal. Recently, acceptable values have decreased as companies have been able to operate more efficiently; today, a current ratio of 1.50 is considered strong. Cash-rich companies like Starbucks and Yum! Brands can operate with a current ratio below 1.0. USING THE DEBT RATIO Decision Guidelines How can you measure a company s ability to pay total liabilities? Who uses the debt ratio for decision making? What is a good value of the debt ratio? Debt ratio = Total liabilities Total assets Lenders and other creditors, who must predict whether a borrower can pay its debts. Stockholders, who know that a company that cannot pay its debts is not a good investment because it may go bankrupt. Managers, who must have enough assets to pay the company s debts. Depends on the industry: A company with strong cash flow can operate successfully with a high debt ratio of, say, A company with weak cash flow needs a lower debt ratio of, say, Traditionally, a debt ratio of 0.50 was considered ideal. Recently, values have increased as companies have been able to operate more efficiently; today, a normal value of the debt ratio is around

38 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income END-OF-CHAPTER SUMMARY PROBLEM Refer to the mid-chapter summary problem that begins on page 148. Required 1. Make Goldsmith Company s closing entries at December 31, 20X5. Explain what the closing entries accomplish and why they are necessary. Show amounts in thousands. 2. Post the closing entries to Retained Earnings and compare Retained Earnings ending balance with the amount reported on the balance sheet on page 151. The two amounts should be the same. 3. Prepare Goldsmith Company s classified balance sheet to identify the company s current assets and current liabilities. (Goldsmith has no long-term liabilities.) Then compute the company s current ratio and debt ratio at December 31, 20X5. 4. The top management of Goldsmith Company has asked you for a $500,000 loan to expand the business. Goldsmith proposes to pay off the loan over a 10-year period. Recompute Goldsmith s debt ratio assuming you make the loan. Use the company financial statements plus the ratio values to decide whether to grant the loan at an interest rate of 8%, 10%, or 12%. Goldsmith s cash flow is strong. Give the reasoning underlying your decision. Answers Requirement 1 20X5 (In thousands) Dec. 31 Service Revenue Retained Earnings Retained Earnings Salary Expense Depreciation Expense Furniture and Fixtures Depreciation Expense Building Supplies Expense... Income Tax Expense Miscellaneous Expense Retained Earnings Dividends Explanation of Closing Entries The closing entries set the balance of each revenue, expense, and Dividends account back to zero for the start of the next accounting period. We must close these accounts because their balances relate only to one accounting period. Requirement 2 Retained Earnings Clo. Clo Clo

39 29366_10_ch3_p /12/07 5:50 PM Page 163 End-of-Chapter Summary Problem 163 The balance in the Retained Earnings account agrees with the amount reported on the balance sheet, as it should. Requirement 3 Goldsmith Company Balance Sheet December 31, 20X5 (Amounts in thousands) Assets Current assets: Cash... Accounts receivable... Supplies... Total current assets... Furniture and fixtures... Less: Accumulated depreciation... Building... Less: Accumulated depreciation... Total assets... $100 (60) $250 (140) $ $732 Liabilities Current liabilities: Accounts payable... Salary payable... Unearned service revenue... Income tax payable... Total current liabilities... Common stock... Retained earnings... Total stockholders equity... Total liabilities and Stockholders Equity stockholders equity... $ $732 Current ratio = $582 = 1.34 $433 $433 Debt ratio = $732 = 0.59 Requirement 4 Debt ratio assuming $433 + $500 = the loan is made $732 + $500 = $933 =.76 $1,232 Decision: Make the loan at 10%. Reasoning: Prior to the loan, the company s financial position and cash flow are strong. The current ratio is in a middle range, and the debt ratio is not too high. Net income (from the income statement) is high in relation to total revenue. Therefore, the company should be able to repay the loan. The loan will increase the company s debt ratio from 59% to 76%, which is more risky than the company s financial position at present. On this basis, a midrange interest rate appears reasonable at least as the starting point for the negotiation between Goldsmith Company and the bank.

40 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income REVIEW ACCRUAL ACCOUNTING & INCOME Quick Check (Answers are given on page 196.) 1. On November 1, Rosewood Apartments received $4,800 from a tenant for three months rent. The receipt was credited to Unearned Rent Revenue. What adjusting entry is needed on December 31? a. Unearned Rent Revenue 3,200 Rent Revenue 3,200 b. Rent Revenue 1,600 Unearned Rent Revenue 1,600 c. Unearned Rent Revenue 1,600 Rent Revenue 1,600 d. Cash 1,600 Rent Revenue 1, The following normal balances appear on the adjusted trial balance of Augusta National Company: Equipment... $90,000 Accumulated depreciation, equipment... 15,000 Depreciation expense, equipment... 5,000 The book value of the equipment is a. $85,000. c. $75,000. b. $70,000. d. $60, Cadillac, Inc., purchased supplies for $900 during 20X3. At year end Cadillac had $600 of supplies left. The adjusting entry should: a. debit Supplies $300. c. credit Supplies $600. b. debit Supplies Expense $300. d. debit Supplies $ The accountant for Eldorado Corp. failed to make the adjusting entry to record depreciation for the current year. The effect of this error is: a. Assets are overstated, stockholders equity and net income are understated. b. Assets and expenses are understated; net income is understated. c. Net income is overstated and liabilities are understated. d. Assets, net income, and stockholders equity are all overstated. 5. Interest earned on a note receivable at December 31 equals $125. What adjusting entry is required to accrue this interest? a. Interest Payable 125 Interest Expense 125 b. Interest Expense 125 Cash 125 c. Interest Receivable 125 Interest Revenue 125 d. Interest Expense 125 Interest Payable If a real estate company fails to accrue commission revenue, a. liabilities are overstated and owners equity is understated. b. assets are understated and net income is understated. c. revenues are understated and net income is overstated. d. net income is understated and stockholders equity is overstated.

41 29366_10_ch3_p /12/07 5:50 PM Page 165 Review Accrual Accounting & Income All of the following statements are true except one. Which statement is false? a. Adjusting entries are required for a business that uses the cash basis. b. Accrual accounting produces better information than cash-basis accounting. c. The matching principle directs accountants to identify and measure all expenses incurred and deduct them from revenues earned during the same period. d. A fiscal year ends on some date other than December The account Unearned Revenue is a(n): a. revenue c. asset b. expense d. liability 9. Adjusting entries: a. are needed to measure the period s net income or net loss. b. update the accounts. c. do not debit or credit cash. d. all of the above. 10. An adjusting entry that debits an expense and credits a liability is which type? a. accrued expense c. prepaid expense b. depreciation expense d. cash expense Use the following data for questions 11 and 12. Here are key figures from the balance sheet of Seville, Inc., at the end of 20X3 (amounts in thousands): December 31, 20X3 Total assets (of which 40% are current)... Current liabilities... Bonds payable (long-term)... Common stock... Retained earnings... Total liabilities and stockholders equity... $4, ,200 1, , Seville s current ratio at the end of 20X3 is: a c b. 2.0 d Seville s debt ratio at the end of 20X3 is: a. 42% (rounded) c. 60% b. 17% (rounded) d. 50% 13. On a trial balance, which of the following would indicate that an error has been made? a. Service Revenue has a debit balance b. Salary Expense has a debit balance c. Accumulated Depreciation has a credit balance d. All of the above indicate errors 14. The entry to close Management Fee Revenue would be: a. Management Fee Revenue does not need to be closed out. b. Retained Earnings Management Fee Revenue c. Management Fee Revenue Retained Earnings d. Management Fee Revenue Service Revenue 15. Which of the following accounts is not closed out? a. Accumulated Depreciation b. Depreciation Expense c. Dividends d. Interest Revenue

42 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income 16. FedEx earns service revenue of $500,000. How does this transaction affect FedEx s ratios? a. Hurts the current ratio and improves the debt ratio. b. Hurts both ratios. c. Improves both ratios. d. Improves the current ratio and doesn t affect the debit ratio. 17. Suppose Starbucks Corporation borrows $50 million on a 10-year note payable. How does this transaction affect Starbucks ratios? a. Improves both ratios. b. Improves the current ratio and hurts the debt ratio. c. Hurts both ratios. d. Hurts the current ratio and improves the debt ratio. Accounting Vocabulary account format (p. 156) A balance-sheet format that lists assets on the left and liabilities and stockholders equity on the right. accrual (p. 132) An expense or a revenue that occurs before the business pays or receives cash. An accrual is the opposite of a deferral. accrual accounting (p. 127) Accounting that records the impact of a business event as it occurs, regardless of whether the transaction affected cash. accrued expense (p. 138) An expense incurred but not yet paid in cash. accrued revenue (p. 139) A revenue that has been earned but not yet received in cash. accumulated depreciation (p. 136) The cumulative sum of all depreciation expense from the date of acquiring a plant asset. adjusted trial balance (p. 145) A list of all the ledger accounts with their adjusted balances. book value (of a plant asset) (p. 137) The asset s cost minus accumulated depreciation. cash-basis accounting (p. 127) Accounting that records only transactions in which cash is received or paid. classified balance sheet (p. 154) A balance sheet that shows current assets separate from long-term assets, and current liabilities separate from long-term liabilities. closing the books (p. 152) The process of preparing the accounts to begin recording the next period s transactions. Closing the accounts consists of journalizing and posting the closing entries to set the balances of the revenue, expense, and dividends accounts to zero. Also called closing the accounts. closing entries (p. 152) Entries that transfer the revenue, expense, and dividends balances from these respective accounts to the Retained Earnings account. contra account (p. 136) An account that always has a companion account and whose normal balance is opposite that of the companion account. current assets (p. 154) An asset that is expected to be converted to cash, sold, or consumed during the next 12 months, or within the business s normal operating cycle if longer than a year. current liabilities (p. 154) A debt due to be paid within one year or within the entity s operating cycle if the cycle is longer than a year. current ratio (p. 157) Current assets divided by current liabilities. Measures a company s ability to pay current liabilities with current assets. debt ratio (p. 157) Ratio of total liabilities to total assets. States the proportion of a company s assets that is financed with debt. deferral (p. 131) An adjustment for which the business paid or received cash in advance. Examples include prepaid rent, prepaid insurance, and supplies. depreciation (p. 132) the cost of a plant asset over its useful life. liquidity (p. 154) Measure of how quickly an item can be converted to cash. long-term assets (p. 154) An asset that is not a current asset. long-term liabilities (p. 154) A liability that is not a current liability. matching principle (p. 129) The basis for recording expenses. Directs accountants to identify all expenses incurred during the period, to measure the expenses, and to match them against the revenues earned during that same period. multi-step income statement (p. 156) An income statement that contains subtotals to highlight important relationships between revenues and expenses.

43 29366_10_ch3_p /12/07 5:50 PM Page 167 Assess Your Progress 167 operating cycle (p. 154) Time span during which cash is paid for goods and services that are sold to customers who pay the business in cash. permanent accounts (p. 152) Asset, liability, and stockholders equity accounts that are not closed at the end of the period. plant assets (p. 135) Long-lived assets, such as land, buildings, and equipment, used in the operation of the business. Also called fixed assets. prepaid expense (p. 130) A category of miscellaneous assets that typically expire or get used up in the near future. Examples include prepaid rent, prepaid insurance, and supplies. report format (p. 155) A balance-sheet format that lists assets at the top, followed by liabilities and stockholders equity below. revenue principle (p. 128) The basis for recording revenues; tells accountants when to record revenue and the amount of revenue to record. single-step income statement (p. 156) An income statement that lists all the revenues together under a heading such as Revenues or Revenues and Gains. Expenses appear in a separate category called Expenses or perhaps Expenses and Losses. temporary accounts (p. 152) The revenue and expense accounts that relate to a limited period and are closed at the end of the period are temporary accounts. For a corporation, the Dividends account is also temporary. time-period concept (p. 128) Ensures that accounting information is reported at regular intervals. unearned revenue (p. 141) A liability created when a business collects cash from customers in advance of earning the revenue. The obligation is to provide a product or a service in the future. ASSESS YOUR PROGRESS Short Exercises S3-1 (Learning Objective 1: Linking accrual accounting and cash flows) Fleetwood Corporation made sales of $700 million during 20X3. Of this amount, Fleetwood collected cash for all but $30 million. The company s cost of goods sold was $300 million, and all other expenses for the year totaled $350 million. Also during 20X3, Fleetwood paid $400 million for its inventory and $280 million for everything else. Beginning cash was $100 million. Fleetwood s top management is interviewing you for a job and they ask two questions: a. How much was Fleetwood s net income for 20X3? (p. 147) b. How much was Fleetwood s cash balance at the end of 20X3? (pp ) You will get the job only if you answer both questions correctly. S3-2 (Learning Objective 1: Linking accrual accounting and cash flows) Docker Corporation began 20X9 owing notes payable of $4.0 million. During 20X9 Docker borrowed $2.6 million on notes payable and paid off $2.5 million of notes payable from prior years. Interest expense for the year was $1.0 million, including $0.2 million of interest payable accrued at December 31, 20X9. Show what Docker should report for these facts on the following financial statements: Income statement (p. 147) Interest expence Balance sheet (p.147) Notes payable Interest payable S3-3 (Learning Objective 2: Applying the revenue and the matching principles) Ford Motor Company sells large fleets of vehicles to auto rental companies, such as Enterprise and Hertz. Suppose Enterprise is negotiating with Ford to purchase 1,000 Explorers. Write a short paragraph to explain to Ford when Ford should, and should not, record this sales revenue and the related expense for cost of goods sold. Mention the accounting principles that provide the basis for your explanation. (p. 128) writing assignment

44 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income S3-4 (Learning Objective 3: Adjusting prepaid expenses) Answer the following questions about prepaid expenses: a. On November 1, Air & Sea Travel prepaid $3,000 for 6 months rent. Give the adjusting entry to record rent expense at December 31. Include the date of the entry and an explanation. Then post all amounts to the 2 accounts involved, and show their balances at December 31. Air & Sea Travel adjusts the accounts only at December 31. (pp ) b. On Dec. 1, Air & Sea Travel paid $800 for supplies. At December 31, Air & Sea Travel has $500 of supplies on hand. Make the required journal entry at December 31. Then post all amounts to the accounts and show their balances at December 31. (pp ) S3-5 (Learning Objective 1, 3: Recording depreciation; cash flows) Suppose that on January 1 Callaway Golf Company paid cash of $30,000 for computers that are expected to remain useful for 3 years. At the end of 3 years, the computers values are expected to be zero. 1. Make journal entries to record (a) purchase of the computers on January 1 and (b) annual depreciation on December 31. Include dates and explanations, and use the following accounts: Computer Equipment; Accumulated Depreciation Computer Equipment; and Depreciation Expense Computer Equipment. (pp ) 2. Post to the accounts and show their balances at December 31. (pp ) 3. What is the computer equipment s book value at December 31? (pp ) S3-6 (Learning Objective 2: Applying the matching principle and the time-period concept) During 20X8, Jetway Airlines paid salary expense of $40 million. At December 31, 20X8, Jetway accrued salary expense of $2 million. Jetway then paid $1.9 million to its employees on January 3, 20X9, the company s next payday after the end of the 20X8 year. For this sequence of transactions, show what Jetway would report on its 20X8 income statement and on its balance sheet at the end of 20X8. (p. 147) S3-7 (Learning Objective 3: Accruing and paying interest expense) Mizuno Travel borrowed $100,000 on October 1 by signing a note payable to Texas First Bank. The interest expense for each month is $500. The loan agreement requires Mizuno to pay interest on December Make Mizuno s adjusting entry to accrue monthly interest expense at October 31, at November 30, and at December 31. Date each entry and include its explanation. (pp ) 2. Post all three entries to the Interest Payable account. You need not take the balance of the account at the end of each month. (pp ) 3. Record the payment of three months interest at December 31. (Challenge) S3-8 (Learning Objective 3: Accruing and receiving cash from interest revenue) Return to the situation in Short Exercise S3-7. Here you are accounting for the same transactions on the books of Texas First Bank, which lent the money to Mizuno Travel. Perform all three steps of Short Exercise S3-7 for Texas First Bank using the bank s own accounts. (pp ) writing assignment S3-9 (Learning Objective 3: Explaining unearned revenues) Write a paragraph to explain why unearned revenues are liabilities instead of revenues. In your explanation, use the following actual example: The Wall Street Journal collects cash from subscribers in advance and later delivers newspapers to subscribers over a 1-year period. Explain what happens to the unearned revenue over the course of a year as The Wall Street Journal delivers papers to subscribers. Into what account does the earned subscription revenue go as The Wall Street Journal delivers papers? Give the journal entries that The Wall Street Journal would make to (a) collect $40,000 of subscription revenue in advance and (b) record earning $40,000 of subscription revenue. Include an explanation for each entry, as illustrated in the chapter. (pp ) S3-10 (Learning Objective 4: Reporting prepaid expenses) Eagle Golf Co. prepaid 3 years rent ($6,000) on January 1. At December 31, Eagle prepared a trial balance and then made the necessary adjusting entry at the end of the year. Eagle adjusts its accounts once each year on December 31.

45 29366_10_ch3_p /12/07 5:50 PM Page 169 Assess Your Progress 169 What amount appears for Prepaid Rent on a. Eagle s unadjusted trial balance at December 31? (pp ) b. Eagle s adjusted trial balance at December 31? (pp ) What amount appears for Rent Expense on c. Eagle s unadjusted trial balance at December 31? (pp ) d. Eagle s adjusted trial balance at December 31? (pp ) S3-11 (Learning Objective 3: Updating the accounts) Bentley, Inc., collects cash from customers two ways: a. Accrued revenue. Some customers pay Bentley after Bentley has performed service for the customer. During 20X8, Bentley made sales of $50,000 on account and later received cash of $40,000 on account from these customers. b. Unearned revenue. A few customers pay Bentley in advance, and Bentley later performs the service for the customer. During 20X8 Bentley collected $7,000 cash in advance and later earned $6,000 of this amount. Journalize for Bentley a. Earning service revenue of $50,000 on account and then collecting $40,000 on account. (pp ) b. Receiving $7,000 in advance and then earning $6,000 as service revenue. (pp ) Explanations are not required. S3-12 (Learning Objective 4: Preparing the financial statements) Falcon Sporting Goods Company reported the following data at March 31, 20X4, with amounts in thousands: Retained earnings, March 31, 20X3... $ 1,300 Accounts receivable... 27,700 Net revenues ,500 Total current liabilities.. 53,600 All other expenses... 45,000 Other current assets... 4,800 Other assets... 24,300 Cost of goods sold... $126,000 Cash Property and equipment, net... 7,200 Common stock... 26,000 Inventories... 33,000 Long-term liabilities... 13,500 Dividends... 0 Use these data to prepare Falcon Sporting Goods Company s income statement for the year ended March 31, 20X4; statement of retained earnings for the year ended March 31, 20X4; and classified balance sheet at March 31, 20X4. Use the report format for the balance sheet. Draw arrows linking the three statements. (pp. 147, 155, 156) S3-13 (Learning Objective 5: Making closing entries) Use the Falcon Sporting Goods data in Short Exercise S3-12 to make the company s closing entries at March 31, 20X4. Then set up a T-account for Retained Earnings and post to that account. Compare Retained Earnings ending balance to the amount reported on Falcon s statement of retained earnings and balance sheet. What do you find? (pp ) S3-14 (Learning Objective 6: Computing the current ratio and the debt ratio) Use the Falcon Sporting Goods data in short Exercise S3-12 to compute Falcon s 1. Current ratio (pp ) 2. Debit ratio (pp ) Round to 2 decimal places. Do these ratio values look strong, weak or middle-of-the-road?

46 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income S3-15 (Learning Objective 6: Using the current ratio and the debit ratio) Use the Falcon Sporting Goods data in Short Exercise S3-12 to compute Falcon s (a) current ratio and (b) debt ratio after each of the following transactions (all amounts in thousands, as in the Falcon financial statements): 1. Falcon earned revenue of $10,000 on account (pp ) 2. Falcon paid off accounts payable of $10,000. (Challenge) Round ratios to 2 decimal places. Exercises Most of the even-numbered exercises can be found within My Accouting Lab (MAL), an online homework and practice environment. Your instructor may ask you to complete these exercises using MAL. E3-16 (Learning Objective 1: Linking accrual accounting and cash flows) During 20X8 Consolidated Foods Corporation made sales of $4,000 (assume all on account) and collected cash of $4,100 from customers. Operating expenses totaled $800, all paid in cash. At year end, 20X8, Consolidated customers owed the company $400. Consolidated owed creditors $700 on account. All amounts are in millions. 1. For these facts, show what Consolidated reported on the following financial statements (p. 147): Income statement Balance sheet 2. Suppose Consolidated had used the cash basis of accounting. What would Consolidated have reported for these facts? (p. 127) E3-17 (Learning Objective 1: Linking accrual accounting and cash flows) During 2009 Valley Sales, Inc., earned revenues of $500,000 on account. Valley collected $510,000 from customers during the year. Expenses totaled $420,000, and the related cash payments were $400,000. Show what Valley would report on its 2009 income statement under the a. Cash basis b. Accrual basis Compute net income under both bases of accounting. Which basis measures net income better? Explain your answer. (p. 127) E3-18 (Learning Objective 1, 2: Accrual basis of accounting, applying accounting principles) During 20X6, Dish Network, Inc., which designs network servers, earned revenues of $700 million. Expenses totaled $540 million. Dish collected all but $20 million of the revenues and paid $550 million on its expenses. Dish s top managers are evaluating 20X6, and they ask you the following questions: a. Under accrual accounting, what amount of revenue should Dish Network report for 20X6? Is the revenue the $700 million earned or is it the amount of cash actually collected? How does the revenue principle help to answer these questions? (pp. 127, 128) b. Under accrual accounting, what amount of total expense should Dish Network report for 20X6 $540 million or $550 million? Which accounting principle helps to answer this question? (pp ) c. Which financial statement reports revenues and expenses? Which statement reports cash receipts and cash payments? (p. 147) writing assignment E3-19 (Learning Objective 2: Applying accounting concepts and principles) Write a short paragraph to explain in your own words the concept of depreciation as used in accounting. (pp ) E3-20 (Learning Objective 2: Applying accounting concepts and principles) Identify the accounting concept or principle that gives the most direction on how to account for each of the following situations: (pp )

47 29366_10_ch3_p /12/07 5:50 PM Page 171 Assess Your Progress 171 a. Salary expense of $20,000 is accrued at the end of the period to measure income properly. b. October has been a particularly slow month, and the business will have a net loss for the third quarter of the year. Management is considering not following its customary practice of reporting quarterly earnings to the public. c. A physician performs a surgical operation and bills the patient s insurance company. It may take 3 months to collect from the insurance company. Should the physician record revenue now or wait until cash is collected? d. A construction company is building a highway system, and construction will take 3 years. When should the company record the revenue it earns? e. A utility bill is received on December 30 and will be paid next year. When should the company record utility expense? E3-21 (Learning Objective 1, 3: Journalizing adjusting entries and analyzing their effects on net income; accrual versus cash basis) An accountant made the following adjustments at December 31, the end of the accounting period: a. Prepaid insurance, beginning, $700. Payments for insurance during the period, $2,100. Prepaid insurance, ending, $800. b. Interest revenue accrued, $900. c. Unearned service revenue, beginning, $800. Unearned service revenue, ending, $300. d. Depreciation, $6,200. e. Employees salaries owed for 3 days of a 5-day work week; weekly payroll, $9,000. f. Income before income tax, $20,000. Income tax rate is 40%. Required 1. Journalize the adjusting entries. (pp ) 2. Suppose the adjustments were not made. Compute the overall overstatement or understatement of net income as a result of the omission of these adjustments. E3-22 (Learning Objective 2, 3: Allocating supplies cost to the asset and the expense) Bird-Kultgen, Inc., experienced four situations for its supplies. Compute the amounts indicated by question marks for each situation. For situations 1 and 2, journalize the needed transaction. Consider each situation separately. (pp ) writing assignment general ledger spreadsheet Situation Beginning supplies... $ 500 $1,000 $300 $ 900 Payments for supplies during the year...? 3,100? 1,100 Total cost to account for... 1,300?? 2,000 Ending supplies ? Supplies expense... $ 900 $? $700 $1,400 E3-23 (Learning Objective 3: Journalizing adjusting entries) Clark Motor Company faced the following situations. Journalize the adjusting entry needed at December 31, 20X6, for each situation. Consider each fact separately. (pp ) a. The business has interest expense of $9,000 that it must pay early in January 20X7. b. Interest revenue of $3,000 has been earned but not yet received. c. On July 1, when we collected $3,000 rent in advance, we debited Cash and credited Unearned Rent Revenue. The tenant was paying us for 2 years rent. d. Salary expense is $1,000 per day Monday through Friday and the business pays employees each Friday. This year, December 31 falls on a Tuesday. e. The unadjusted balance of the Supplies account is $3,100. The total cost of supplies on hand is $800. (continued) general ledger

48 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income f. Equipment was purchased at the beginning of this year at a cost of $60,000. The equipment s useful life is 5 years. Record depreciation for this year and then determine the equipment s book value. E3-24 (Learning Objective 3: Making adjustments in T-accounts) The accounting records of Belmont Publishing Company include the following unadjusted balances at May 31: Accounts Receivable, $1,300; Supplies, $900; Salary Payable, $0; Unearned Service Revenue, $800; Service Revenue, $14,400; Salary Expense, $4,200; Supplies Expense, $0. Belmont s accountant develops the following data for the May 31 adjusting entries: a. Supplies on hand, $300. b. Salary owed to employees, $2,000. c. Service revenue accrued, $600. d. Unearned service revenue that has been earned, $700. Open the foregoing T-accounts with their beginning balances. Then record the adjustments directly in the accounts, keying each adjustment amount by letter. Show each account s adjusted balance. Journal entries are not required. (p. 144) E3-25 (Learning Objective 4: preparing the financial statements) The adjusted trial balance of Honeybee Hams, Inc., follows. Honeybee Hams, Inc. Adjusted Trial Balance December 31, 20X6 Adjusted Trial Balance (Thousands) Debit Credit Cash... Accounts receivable... Inventories... Prepaid expenses... Property, plant, equipment... Accumulated depreciation... Other assets... Accounts payable... Income tax payable... Other liabilities... Common stock... Retained earnings (beginning, December 31, 20X5)... Dividends... Sales revenue... Cost of goods sold... Selling, administrative, and general expense... Income tax expense... Total... $ 3,300 1,800 1,100 1,900 6,600 9,900 1,700 25,000 10,000 2,000 $63,300 $ 2,400 7, ,200 4,900 4,500 41,000 $63,300 Required Prepare Honeybee Hams, Inc. s, income statement and statement of retained earnings for the year ended December 31, 20X6, and its balance sheet on that date. Draw the arrows linking the three statements. (p. 147)

49 29366_10_ch3_p /12/07 5:50 PM Page 173 Assess Your Progress 173 E3-26 (Learning Objective 3: Measuring financial statement amounts) The adjusted trial balances of Triumph Corporation at March 31, 2008, and March 31, 2007, include these amounts (in millions): Receivables... $300 $200 Prepaid insurance Accrued liabilities payable (for other operating expenses) Triumph completed these transactions during the year ended March 31, Collections from customers... $20,800 Payment of prepaid insurance Cash payments for other operating expenses... 4,100 Compute the amount of sales revenue, insurance expense, and other operating expenses to report on the income statement for the year ended March 31, (pp ) E3-27 (Learning Objective 4: Reporting on the financial statements) This question deals with the items and the amounts that two entities, Mother Frances Hospital (Mother Frances) and City of St. Paul (St. Paul) should report in their financial statements. Fill in the blanks. Required 1. On July 1, 20X5, Mother Frances collected $3,000 in advance from St. Paul, a client. Under the contract, Mother Frances is obligated to perform medical exams for City of St. Paul employees evenly during the 12 months ending June 30, 20X6. Assume you are Mother Frances. Mother Frances s income statement for the year ended December 31, 20X5, will report of $. (pp , 147) Mother Frances s balance sheet at December 31, 20X5, will report of $. (pp , 147) 2. Assume now that you are City of St. Paul (St. Paul). St. Paul s income statement for the year ended December 31, 20X5, will report of $. (pp. 132, 147) St. Paul s balance sheet at December 31, 20X5, will report of $. (pp. 132, 147) E3-28 (Learning Objective 1, 3: Linking deferrals and cash flows) This exercise builds from a simple situation to a slightly more complex situation. Vodafone, the British wireless phone service provider, collects cash in advance from customers. All amounts are in millions of pounds sterling, ( ) the British monetary unit. Assume Vodafone collected 500 in advance during 2008 and at year end still owed customers phone service worth 100. Required 1. Show what Vodafone will report for 2008 on its (pp , 147) Income statement Balance sheet (continued)

50 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income 2. Use the same facts for Vodafone as in item 1. Further, assume Vodafone reported unearned service revenue of 70 back at the end of Show what Vodafone will report for 2008 on the same financial statements. Explain why your answer here differs from your answer to item 1. (pp , 147) E3-29 (Learning Objective 5: Closing the accounts) Prepare the closing entries from the following selected accounts from the records of Ulrich Corporation at December 31, 20X2: Cost of services sold... $11,600 Accumulated depreciation... 17,800 Selling, general, and administrative expense... 6,900 Retained earnings, December 31, 20X1... 1,900 Service revenue... $23,600 Depreciation expense... 4,100 Other revenue Dividends Income tax expense Income tax payable How much net income did Ulrich earn during 20X2? (p. 147) Prepare a T-account for Retained Earnings to show the December 31, 20X2, balance of Retained Earnings. (p. 153) E3-30 (Learning Objective 3, 5: Identifying and recording adjusting and closing entries) The unadjusted trial balance and income statement amounts from the December 31 adjusted trial balance of Kopec Production Company follow. Required Journalize the adjusting and closing entries of Kopec Production Company at December 31. There was only one adjustment to Service Revenue. (pp. 144, 153) Kopec Production Company Account Title Unadjusted Trial Balance From the Adjusted Trial Balance Cash... Prepaid rent... Equipment... Accumulated depreciation... Accounts payable... Salary payable... Unearned service revenue... Income tax payable... Note payable, long-term... Common stock... Retained earnings... Dividends... Service revenue... Salary expense... Rent expense... Depreciation expense... Income tax expense... Net income... 10,200 1,100 32,100 1,000 4,000 1,200 49,600 3,800 4,600 8,400 10,000 8,700 1,300 12,800 49,600 4,900 1, ,600 8,200 19,500 19,500

51 29366_10_ch3_p /12/07 5:50 PM Page 175 Assess Your Progress 175 E3-31 (Learning Objective 4, 6: Preparing a classified balance sheet and using the ratios) Refer to Exercise Required 1. After solving Exercise 3-30, use the data in that exercise to prepare Kopec Production Company s classified balance sheet at December 31 of the current year. Use the report format. First you must compute the adjusted balance for several of the balance-sheet accounts. (pp , ). 2. Compute Kopec Production Company s current ratio and debt ratio at December 31. A year ago, the current ratio was 1.55 and the debt ratio was Indicate whether the company s ability to pay its debts both current and total improved or deteriorated during the current year. (pp ) E3-32 (Learning Objective 6: Measuring the effects of transactions on the ratios) Ben Williams Company reported these ratios at December 31, 2008 (dollar amounts in millions): Current ratio = $20 = 2.00 $10 $20 Debt ratio = $50 = 0.40 Ben Williams Company completed these transactions during 2009: a. Purchased equipment on account, $4. b. Paid long-term debt, $5. c. Collected cash from customers in advance, $2. d. Accrued interest expense, $1. e. Made cash sales, $6. Determine whether each transaction improved or hurt Williams current ratio and debt ratio. Round all ratios to 2 decimal places. (pp ) Serial Exercise Exercise 3-33 continues the Lance Sedberry, Certified Public Accountant, P.C., situation begun in Exercise 2-25 of Chapter 2 (p. 95). E3-33 (Learning Objectives 3, 4, 5, 6: Adjusting the accounts, preparing the financial statements, closing the accounts, and evaluating the business) Refer to Exercise 2-25 of Chapter 2. Start from the trial balance and the posted T-accounts that Lance Sedberry, Certified Public Accountant, Professional Corporation (P.C.), prepared for his accounting practice at January 18. A professional corporation is not subject to income tax. Later in January, the business completed these transactions: general ledger Jan. 21 Received $900 in advance for tax work to be performed over the next 30 days. 21 Hired a secretary to be paid on the 15th day of each month. 26 Paid $900 on account. 28 Collected $600 on account. 31 Declared and paid dividends of $1,000. Required 1. Open these T-accounts: Accumulated Depreciation Equipment, Accumulated Depreciation Furniture, Salary Payable, Unearned Service Revenue, Retained Earnings, Depreciation Expense Equipment, Depreciation Expense Furniture, and Supplies Expense. Also, use the T-accounts that you opened for Exercise (pp ). 2. Journalize the transactions of January 21 through 31. (pp ) 3. Post the January 21 to 31 transactions to the T-accounts, keying all items by date. (pp ) (continued)

52 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income 4. Prepare a trial balance at January 31. Also set up columns for the adjustments and for the adjusted trial balance, as illustrated in Exhibit 3-9, page At January 31, Sedberry gathers the following information for the adjusting entries: a. Accrued service revenue, $1,000. b. Earned $300 of the service revenue collected in advance on January 21. c. Supplies on hand, $300. d. Depreciation expense equipment, $100; furniture, $200. e. Accrued expense for secretary s salary, $700. Make these adjustments directly in the adjustments columns and complete the adjusted trial balance at January 31. (pp ) 6. Journalize and post the adjusting entries. Denote each adjusting amount as Adj. and an account balance as (pp ) 7. Prepare the income statement and statement of retained earnings of Lance Sedberry, Certified Public Accountant, P.C., for the month ended January 31 and the classified balance sheet at that date. Draw arrows to link the financial statements. (p. 147) 8. Journalize and post the closing entries at January 31. Denote each closing amount as Clo. and an account balance as (p. 153) 9. Compute the current ratio and the debt ratio of Sedberry s accounting practice and evaluate these ratio values as indicative of a strong or weak financial position. (pp ) Challenge Exercises E3-34 (Learning Objective 6: Evaluating the current ratio) Valley Forge Corporation reported the following current accounts at December 31, 2008 (amounts in thousands): Cash... Receivables... Inventory... Prepaid expenses... $1,700 5,600 1, Accounts payable... Unearned revenues... Accrued expenses payable... 2,400 1,200 1,700 During 2009, Valley Forge completed these selected transactions: Sold services on account, $8,500. Depreciation expense, $400. Paid for expenses, $7,100. Collected from customers on account, $7,500. Accrued expenses, $300. Paid on account, $1,000. Used up prepaid expenses, $200. Compute Valley Forge s current ratio at December 31, 2008, and again at December 31, Did the current ratio improve or deteriorate during 2009? Comment on the level of the company s current ratio. (pp ) E3-35 (Learning Objective 3, 4: Computing financial statement amounts) The accounts of Gleneagles Company prior to the year-end adjustments follow on the next page. Adjusting data at the end of the year include: a. Unearned service revenue that has been earned, $1,000. b. Accrued service revenue, $2,000. c. Supplies used in operations, $3,000. d. Accrued salary expense, $3,000. e. Perpaid insurance expired, $1,000. f. Depreciation expense building, $2,000.

53 29366_10_ch3_p /12/07 5:50 PM Page 177 Assess Your Progress 177 Cash... Accounts receivable... Supplies... Prepaid insurance... Building... Accumulated depreciation building... Land... Accounts payable... Salary payable... Unearned service revenue... $ 4,000 7,000 4,000 3, ,000 14,000 51,000 6,000 5,000 Common stock... $ 10,000 Retained earnings... 43,000 Dividends... 16,000 Service revenue ,000 Salary expense... 32,000 Depreciation expense building... Supplies expense... Insurance expense... Advertising expense... 7,000 Utilities expense... 2,000 Mack Shaughnessy, the principal stockholder, has received an offer to sell Gleneagles Company. He needs to know the following information within 1 hour: a. Net income for the year covered by these data b. Total assets c. Total liabilities d. Total stockholders equity e. Proof that total assets = total liabilities + total stockholders equity after all items are updated. Required Without opening any accounts, making any journal entries, or using a work sheet, provide Mr. Shaughnessy with the requested information. The business is not subject to income tax. Show all computations. (pp , 147) Practice Quiz Test your understanding of accrual accounting by answering the following questions. Select the best choice from among the possible answers given. Questions are based on the following facts: Freddie Handel began a music business in July 20X4. Handel prepares monthly financial statements and uses the accrual basis of accounting. The following transactions are Handel Company s only activities during January through April: Jan. 14 Bought music on account for $10, with payment to the supplier due in 90 days. Feb. 3 Performed a job on account for Joey Bach for $25, collectible from Bach in 30 days. Used up all the music purchased on Jan. 14. Mar. 16 Collected the $25 receivable from Bach. Apr. 22 Paid the $10 owed to the supplier from the January 14 transaction. Q3-36 In which month should Handel record the cost of the music as an expense? (pp ) a. January c. March b. February d. April Q3-37 In which month should Handel report the $25 revenue on its income statement? (pp ) a. January c. March b. February d. April

54 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Q3-38 If Handel Company uses the cash basis of accounting instead of the accrual basis, in what month will Handel report revenue and in what month will it report expense? (pp ) Revenue Expense a. March April b. March January c. February April d. March February Q3-39 In which month should revenue be recorded? (p. 129) a. In the month that goods are ordered by the customer. b. In the month that goods are shipped to the customer. c. In the month that the invoice is mailed to the customer. d. In the month that cash is collected from the customer. Q3-40 On January 1 of the current year, Aladdin Company paid $600 rent to cover six months (January June). Aladdin recorded this transactions as follows: Prepaid Rent Cash Aladdin adjusts the accounts at the end of each month. Based on these facts, the adjusting entry at the end of January should include (p. 132) a. a credit to Prepaid Rent for $500. b. a debit to Prepaid Rent for $500. c. a debit to Prepaid Rent for $100. d. a credit to Prepaid Rent for $100. Q3-41 Assume the same facts as in the previous problem. Aladdin s adjusting entry at the end of February should include a debit to Rent Expense in the amount of (p. 132) a. $-0-. c. $200. b. $500. d. $100. Q3-42 What effect does the adjusting entry in question 41 have on Aladdin s net income for February? (p. 132) a. increase by $100 c. decrease by $100 b. increase by $200 d. decrease by $200 Q3-43 An adjusting entry recorded March salary expense that will be paid in April. Which statement best describes the effect of this adjusting entry on the company s accounting equation at the end of March? (p. 139) a. Assets are not affected, liabilities are increased, and stockholders equity is decreased. b. Assets are decreased, liabilities are increased, and stockholders equity is decreased. c. Assets are not affected, liabilities are increased, and stockholders equity is increased. d. Assets are decreased, liabilities are not affected, and stockholders equity is decreased. Q3-44 On April 1, 20X1, Metro Insurance Company sold a one-year insurance policy covering the year ended April 1, 20X2. Metro collected the full $1,200 on April 1, 20X1. Metro made the following journal entry to record the receipt of cash in advance: Cash Unearned Revenue 1,200 1,200 Nine months have passed, and Metro has made no adjusting entries. Based on these facts, the adjusting entry needed by Metro at December 31, 20X1, is (pp )

55 29366_10_ch3_p /12/07 5:50 PM Page 179 Assess Your Progress 179 a. b. c. d. Unearned Revenue Insurance Revenue Insurance Revenue Unearned Revenue Unearned Revenue Insurance Revenue Insurance Revenue Unearned Revenue Q3-45 The Unearned Revenue account of Dean, Incorporated, began 20X5 with a normal balance of $5,000 and ended 20X5 with a normal balance of $12,000. During 20X5, the Unearned Revenue account was credited for $19,000 that Dean will earn later. Based on these facts, how much revenue did Dean earn in 20X5? (pp ) a. $5,000 c. $24,000 b. $19,000 d. $12,000 Q3-46 What is the effect on the financial statements of recording depreciation on equipment? (pp. 134, 147) a. Assets are decreased, but net income and stockholders equity are not affected. b. Net income, assets, and stockholders equity are all decreased. c. Net income and assets are decreased, but stockholders equity is not affected. d. Net income is not affected, but assets and stockholders equity are decreased. Q3-47 For 20X3, Monterrey Company had revenues in excess of expenses. Which statement describes Monterrey s closing entries at the end of 20X3? (p. 153) a. Revenues will be debited, expenses will be credited, and retained earnings will be debited. b. Revenues will be credited, expenses will be debited, and retained earnings will be debited. c. Revenues will be debited, expenses will be credited, and retained earnings will be credited. d. Revenues will be credited, expenses will be debited, and retained earnings will be credited. Q3-48 Which of the following accounts would not be included in the closing entries? (p. 153) a. Accumulated Depreciation b. Service Revenue c. Depreciation Expense d. Retained Earnings Q3-49 A major purpose of preparing closing entries is to (p. 152) a. zero out the liability accounts. b. close out the Supplies account. c. adjust the asset accounts to their correct current balances. d. update the Retained Earnings account. Q3-50 Selected data for Austin Company follow: Current assets... $50,000 Current liabilities... $40,000 Long-term assets... 70,000 Long-term liabilities... 35,000 Total revenues... 30,000 Total expenses... 20,000 Based on these facts, what are Austin s current ratio and debt ratio? (pp ) Current ratio Debt ratio a. 2 to to 1 b..83 to to 1 c to to 1 d. 2 to to 1

56 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Q3-51 Unadjusted net income equals $5,000. After the following adjustments, net income will be (fill in the blank) $ (pp. 144, 147, Challenge) (1) Salaries payable to employees, $500. (2) Interest due on note payable at the bank, $100. (3) Unearned revenue that has been earned, $600. (4) Supplies used, $200. Q3-52 Salary Payable at the beginning of the month totals $24,000. During the month salaries of $125,000 were accrued as expense. If ending Salary Payable is $10,000, what amount of cash did the company pay for salaries during the month? (Hint: Draw a T-account, as on pp ). a. $129,000 c. $125,000 b. $149,000 d. $139,000 Problems (Group A) Some of these A problems can be found within My Accounting Lab (MAL), an online homework and practice environment. Your instructor may ask you to complete these exercises using MAL. P3-53A (Learning Objective 1: Linking accrual accounting and cash flows) Cherokee Corporation earned revenues of $35 million during 20X1 and ended the year with net income of $8 million. During 20X1, Cherokee collected $33 million from customers and paid cash for all of its expenses plus an additional $1 million for amounts payable at December 31, 20X0. Answer these questions about Cherokee s operating results, financial position, and cash flows during 20X1: Required 1. How much were Cherokee s total expenses? Show your work. (pp ) 2. Identify all the items that Cherokee will report on its 20X1 income statement. Show each amount. (p. 147) 3. Cherokee began 20X1 with receivables of $4 million. All sales are on account. What was the company s receivables balance at the end of 20X1? Identify the appropriate financial statement, and show how Cherokee will report ending receivables in the 20X1 annual report. (pp ) 4. Cherokee began 20X1 owing accounts payable of $9 million. All expenses are increased on account. During 20X1 Cherokee paid $28 million on account. How much in accounts payable did the company owe at the end of the year? Identify the appropriate financial statement and show how Cherokee will report accounts payable in its 20X1 annual report. (pp ) P3-54A (Learning Objective 1: Cash basis versus accrual basis) Masters Consulting had the following selected transactions in August: Aug. 1 Prepaid insurance for August through December, $1, Purchased software for cash, $ Performed service and received cash, $ Paid advertising expense, $ Performed service on account, $3, Purchased computer on account, $1, Collected for the August 11 service. 26 Paid account payable from August Paid salary expense, $ Adjusted for August insurance expense (see Aug. 1). 31 Earned revenue of $800 that was collected in advance back in July.

57 29366_10_ch3_p /12/07 5:50 PM Page 181 Assess Your Progress 181 Required 1. Show how each transaction would be handled using the cash basis and the accrual basis. Under each column, give the amount of revenue or expense for August. Journal entries are not required. Use the following format for your answer, and show your computations: (pp ) Date Masters Consulting Amount of Revenue (Expense) for August Cash Basis Accrual Basis 2. Compute August income (loss) before tax under each accounting method. (p. 125) 3. Indicate which measure of net income or net loss is preferable. Use the transactions on August 11 and 24 to explain. (p. 127) P3-55A (Learning Objective 1, 2: Applying accounting principles) Write a memo to explain for a new employee the difference between the cash basis of accounting and the accrual basis. Mention the roles of the revenue principle and the matching principle in accrual accounting. (pp ) P3-56A (Learning Objective 3: Making accounting adjustments) Journalize the adjusting entry needed on December 31, end of the current accounting period, for each of the following independent cases affecting Callaway Corp. Include an explanation for each entry. (pp ) a. Details of Prepaid Insurance are shown in the account: writing assignment Prepaid Insurance Jan Mar. 31 3,600 Callaway prepays insurance on March 31 each year. At December 31, $600 is still prepaid. b. Callaway pays employees each Friday. The amount of the weekly payroll is $6,000 for a 5-day work week. The current accounting period ends on Wednesday. c. Callaway has a note receivable. During the current year, Callaway has earned accrued interest revenue of $500 that it will collect next year. d. The beginning balance of supplies was $2,600. During the year, Callaway purchased supplies costing $6,100, and at December 31 supplies on hand total $2,100. e. Callaway is providing services for Manatee Investments, and the owner of Manatee paid Callaway $12,000 as the annual service fee. Callaway recorded this amount as Unearned Service Revenue. Callaway estimates that it has earned one-third of the total fee during the current year. f. Depreciation for the current year includes Office Furniture, $1,000 and Equipment, $2,700. Make a compound entry.

58 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income P3-57A (Learning Objective 3, 4, 6: Preparing an adjusted trial balance and the financial statements; using the current ratio to evaluate the business) The unadjusted trial balance of Princess, Inc., at January 31, 20X2, and the related month-end adjustment data follow. Princess, Inc. Trial Balance January 31, 20X2 Cash... Accounts receivable... Prepaid rent... Supplies... Furniture... Accumulated depreciation... Accounts payable... Salary payable... Common stock... Retained earnings (December 31, 20X1)... Dividends... Service revenue... Salary expense... Rent expense... Utilities expense... Depreciation expense... Supplies expense... Total... $ 8,000 10,000 3,000 2,000 36,000 4,000 2,000 1,000 $66,000 $ 3,000 10,000 26,000 13,000 14,000 $66,000 Adjustment data: a. Accrued service revenue at January 31, $2,000. b. Prepaid rent expired during the month. The unadjusted prepaid balance of $3,000 relates to the period January through March. c. Supplies used during January, $2,000. d. Depreciation on furniture for the month. The estimated useful life of the furniture is 3 years. e. Accrued salary expense at January 31 for Monday, Tuesday, and Wednesday. The 5-day weekly payroll of $5,000 will be paid on Friday, February 2. Required 1. Using Exhibit 3-9, page 145, as an example, prepare the adjusted trial balance of Princess, Inc., at January 31, 20X2. Key each adjusting entry by letter. 2. Prepare the monthly income statement, the statement of retained earnings, and the classified balance sheet. Draw arrows linking the three financial statements. (p. 147) P3-58A (Learning Objective 3: Analyzing and recording adjustments) Peppertree Apartments, Inc. s, unadjusted and adjusted trial balances at April 30, 20X1, is given on the next page.

59 29366_10_ch3_p /12/07 5:50 PM Page 183 Assess Your Progress 183 Peppertree Apartments, Inc. Adjusted Trial Balance April 30, 20X1 Trial Balance Adjusted Trial Balance Account Title Debit Credit Debit Credit Cash Accounts receivable Interest receivable Note receivable Supplies Prepaid insurance Building Accumulated depreciation Accounts payable Wages payable Unearned rental revenue Common stock Retained earnings Dividends Rental revenue Interest revenue Wage expense Insurance expense Depreciation expense Property tax expense Supplies expense Utilities expense 8,300 6,300 4, ,400 66,400 3,600 1, ,100 16,000 6, ,000 42,700 9,900 94,100 8,300 6, , ,400 3,600 2,000 1,700 2, ,500 18,200 6, ,000 42,700 10, ,500 Required 1. Make the adjusting entries that account for the differences between the two trial balances. (p. 145) 2. Compute Peppertree s total assets, total liabilities, total equity, and net income. (p. 147) general ledger P3-59A (Learning Objective 4, 6: Preparing the financial statements and using the debt ratio) The adjusted trial balance of Snead Corporation, at December 31, 20X6, follows on the next page. Required 1. Prepare Snead Corporation s 20X6 income statement, statement of retained earnings, and balance sheet. List expenses (except for income tax) in decreasing order on the income statement and show total liabilities on the balance sheet. Draw arrows linking the three financial statements. (p. 147) spreadsheet (continued)

60 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income 2. Snead s lenders require that the company maintain a debt ratio no higher than Compute Snead s debt ratio at December 31, 20X6, to determine whether the company is in compliance with this debt restriction. If not, suggest a way that Snead could have avoided this difficult situation. (pp ) Snead Corporation Adjusted Trial Balance December 31, 20X6 Cash... Accounts receivable... Supplies... Prepaid rent... Equipment... Accumulated depreciation... Accounts payable... Interest payable... Unearned service revenue... Income tax payable... Note payable... Common stock... Retained earnings... Dividends... Service revenue... Depreciation expense... Salary expense... Rent expense... Interest expense... Insurance expense... Supplies expense... Income tax expense... Total... $ 1,400 8,900 2,300 1,600 37,100 24,000 1,600 39,900 10,300 3,100 3,800 2,900 7,100 $144,000 $ 4,300 3, ,100 18,600 5,000 1, ,900 $144,000 P3-60A (Learning Objective 5: Closing the books and evaluating retained earnings) The accounts of Meadowbrook Services, Inc., at March 31, 20X3, are listed in alphabetical order. Accounts payable... $14,700 Interest expense... $ 600 Accounts receivable... 16,500 6,200 Accumulated depreciation 14,100 equipment... 7,100 5,300 Advertising expense... 10,900 Cash... 7,500 Common stock... 9,100 Current portion of note payable Depreciation expense... 1,900 Dividends... 31,200 Equipment... 43,200 Note payable, long-term... Other assets... Prepaid expenses... Retained earnings, March 31, 20X2... Salary expense... Salary payable... Service revenue... Supplies... Supplies expense... Unearned service revenue... 20,200 17,800 2,400 94,100 3,800 4,600 2,800

61 29366_10_ch3_p /12/07 5:50 PM Page 185 Assess Your Progress 185 Required 1. All adjustments have been journalized and posted, but the closing entries have not yet been made. Journalize Meadowbrook s closing entries at March 31, 20X3. (p. 153) 2. Set up a T-account for Retained Earnings and post to that account. Compute Meadowbrook s net income for the year ended March 31, 20X3. What is the ending balance of Retained Earnings? (pp ) 3. Did Retained Earnings increase or decrease during the year? What caused the increase or the decrease? (p. 153). P3-61A (Learning Objective 4, 6: Preparing a classified balance sheet and using the ratios to evaluate the business) Refer back to Problem 3-60A. 1. Use the Meadowbrook Services data in Problem 3-60A to prepare the company s classified balance sheet at March 31, 20X3. Show captions for total assets, total liabilities, and total liabilities and stockholders equity. (p. 155) 2. Compute Meadowbrook s current ratio and debt ratio at March 31, 20X3, rounding to 2 decimal places. At March 31, 20X2, the current ratio was 1.30 and the debt ratio was Did Meadbrook s ability to pay both current and total debts improve or deteriorate during 20X3? Evaluate Meadowbrook s debt position as strong or weak and give your reason. (pp ) P3-62A (Learning Objectives 6: Analyzing financial ratios) This problem demonstrates the effects of transactions on the current ratio and the debt ratio of Hialeah Company. Hialeah s condensed and adapted balance sheet at December 31, 20X6, is: (In millions) Total current assets... $15.5 Properties, plant, equipment, and other assets $31.3 Total current liabilities... $ 9.2 Total long-term liabilities Total stockholders equity $31.3 Assume that during the first quarter of the following year, 20X7, Hialeah completed the following transactions: a. Paid half the current liabilities. b. Borrowed $3 million on long-term debt. c. Earned revenue, $2.5 million, on account. d. Paid selling expense of $1 million. e. Accrued general expense of $0.8 million. Credit General Expense Payable, a current liability. f. Purchased equipment for $4.2 million, paying cash of $1.4 million and signing a longterm note payable for $2.8 million. g. Recorded depreciation expense of $0.6 million. Required 1. Compute Hialeah s current ratio and debt ratio at December 31, 20X6. Round to 2 decimal places. (pp ) 2. Consider each transaction separately. Compute Hialeah s current ratio and debt ratio after each transaction during 20X7, that is, 7 times. Round ratios to 2 decimal places. (pp ) (continued)

62 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income 3. Based on your analysis, you should be able to readily identify the effects of certain transactions on the current ratio and the debt ratio. Test your understanding by completing these statements with either increase or decrease : (pp ) a. Revenues usually the current ratio. b. Revenues usually the debt ratio. c. Expenses usually the current ratio. (Note: Depreciation is an exception to this rule.) d. Expenses usually the debt ratio. e. If a company s current ratio is greater than 1.0, as it is for Hialeah, paying off a current liability will always the current ratio. f. Borrowing money on long-term debt will always the current ratio and the debt ratio. (Group B) P3-63B (Learning Objective 1: Linking accural accounting and cash flows) During 20X1, Schubert, Inc., earned revenues of $19 million from the sale of its products. Schubert ended the year with net income of $4 million. Schubert collected cash of $20 million from customers and paid cash for all 20X1 expenses plus an additional $3 million on account for amounts payable at the end of 20X0. Answer these questions about Schubert s operating results, financial position, and cash flows during 20X1: 1. How much were Schubert s total expenses? Show your work. (pp ) 2. Identify all the items that Schubert will report on its income statement for 20X1. Show each amount. (p. 147) 3. Schubert began 20X1 with receivables of $6 million. All sales are on account. What was Schubert s receivables balance at the end of 20X1? Identify the appropriate financial statement and show how Schubert will report its ending receivables balance in the company s 20X1 annual report. (pp ) 4. Schubert began 20X1 owing accounts payable of $9 million. Schubert incurs all expenses on account. During 20X1, Schubert paid $18 million on account. How much in accounts payable did Schubert owe at the end of 20X1? Identify the appropriate financial statement and show how Schubert will report accounts payable in its 20X1 annual report. (pp ) P3-64B (Learning Objective 1: Cash basis versus accrual basis) Bombay Foods had the following selected transactions during November: Nov. 1 Received $800 in advance for food to be delivered later. 5 Paid electricity expenses, $ Received cash for the day s sales, $2, Purchased two food warmers, $1, Served a banquet, receiving a note receivable, $ Accrued salary expense, $ Prepaid building rent for December and January, $3,000. Required 1. Show how each transaction would be handled using the cash basis and the accrual basis. Under each column, give the amount of revenue or expense for November. Journal entries are not required. Use the following format for your answer, and show your computations: (pp )

63 29366_10_ch3_p /12/07 5:50 PM Page 187 Assess Your Progress 187 Date Amount of Revenue (Expense) for November Cash Basis Accrual Basis 2. Compute income (loss) before tax for November under the two accounting methods. (p. 147) 3. Which method better measures income and assets? Use the last transaction to explain. (p. 127) P3-65B (Learning Objective 1, 2: Applying accounting principles) As the controller of Avon Systems, you have hired a new employee, whom you must train. He objects to making an adjusting entry for accrued salaries at the end of the period. He reasons, We will pay the salaries soon. Why not wait until payment to record the expense? In the end, the result will be the same. Write a reply to explain to the employee why the adjusting entry is needed for accrued salary expense. (pp ) P3-66B (Learning Objective 3: Making accounting adjustments) Journalize the adjusting entry needed on December 31, the end of the current accounting period, for each of the following independent cases affecting Chicago Mercantile Services (CMS). Include an explanation for each entry. (pp ) a. Each Friday, CMS pays employees for the current week s work. The amount of the payroll is $2,000 for a 5-day work week. The current accounting period ends on Tuesday. b. CMS has received notes receivable from some clients for professional services. During the current year, CMS has earned accrued interest revenue of $1,100, which will be received next year. c. The beginning balance of Supplies was $1,800. During the year, CMS purchased supplies costing $12,500, and at December 31 the inventory of supplies on hand is $2,900. d. CMS is conducting market research, and the client paid CMS $20,000 at the start of the project. CMS recorded this amount as Unearned Service Revenue. The research will take several months to complete. CMS executives estimate that the company has earned three-fourths of the revenue during the current year. e. Depreciation for the current year includes Equipment, $6,300; and Building, $3,700. Make a compound entry. f. Details of Prepaid Insurance are shown in the account: Prepaid Insurance Jan. 1 1,800 Sept. 30 3,600 CMS pays the annual insurance premium (the payment for insurance coverage is called a premium) on September 30 each year. At December 31, $2,700 is still prepaid. P3-67B (Learning Objective 3, 4, 6: Preparing an adjusted trial balance and the financial statements; using the current ratio to evaluate the business) Consider the unadjusted trial balance of Omega Advertising, Inc., at October 31, 20X2, and the related month-end adjustment data. (continued)

64 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Omega Advertising, Inc. Trial Balance October 31, 20X2 Cash... Accounts receivable... Prepaid rent... Supplies... Furniture... Accumulated depreciation... Accounts payable... Salary payable... Common stock... Retained earnings (September 30, 20X2)... Dividends... Advertising revenue... Salary expense... Rent expense... Utilities expense... Depreciation expense... Supplies expense... Total... $16,300 7,000 4, ,000 4,600 4, $73,200 $ 3,000 8,800 15,000 21,000 25,400 $73,200 Adjustment data: a. Accrued advertising revenue at October 31, $2,900. b. Prepaid rent expired during the month. The unadjusted prepaid balance of $4,000 relates to the period October 20X2 through January 20X3. c. Supplies used during October, $200. d. Depreciation on furniture for the month. The furniture s expected useful life is 5 years. e. Accrued salary expense at October 31 for Monday through Thursday; the 5-day weekly payroll is $2,000. Required 1. Using Exhibit 3-9, page 145, as an example, prepare the adjusted trial balance of Omega Advertising at October 31, 20X2. Key each adjusting entry by letter. 2. Prepare the monthly income statement, the statement of retained earnings, and the classified balance sheet. Draw arrows linking the three financial statements. (p. 147) P3-68B (Learning Objective 3: Analyzing and recording adjustments) Valero Sales Company s unadjusted and adjusted trial balances at December 31, 20X7, are given on the next page. Required 1. Make the adjusting entries that account for the differences between the two trial balances. (p. 145) 2. Compute Valero s total assets, total liabilities, total equity, and net income. (p. 147)

65 29366_10_ch3_p /12/07 5:50 PM Page 189 Assess Your Progress 189 Valero Sales Company Adjusted Trial Balance December 31, 20X7 Trial Balance Adjusted Trial Balance Account Title Debit Credit Debit Credit Cash Accounts receivable Supplies Prepaid insurance Office furniture Accumulated depreciation Accounts payable Salary payable Interest payable Note payable Unearned commission revenue Common stock Retained earnings Dividends Sales commission revenue Depreciation expense Supplies expense Utilities expense Salary expense Rent expense Interest expense Insurance expense 4,100 11,200 1,000 2,600 21,600 18,300 4,900 26,600 12, ,300 8,200 6,300 6,000 1,500 5,000 3,500 72, ,300 4,100 12, ,600 18,300 1, ,900 27,500 12,200 1,200 1, ,900 9,300 6, ,000 1,100 5,000 3,500 74, ,900 P3-69B (Learning Objective 4, 6: Preparing the financial statements and using the debt ratio) The adjusted trial balance of Duff & Carson, Inc., at December 31, 20X1, follows on the next page. Required 1. Prepare Duff & Carson s 20X1 income statement, statement of retained earnings, and balance sheet. List expenses in decreasing order on the income statement and show total liabilities on the balance sheet. Draw arrows linking the 3 financial statements. (p. 147) 2. Compute Duff & Carson s debt ratio at December 31, 20X1, rounding to 2 decimal places. Evaluate the company s debt ratio as strong or weak. (pp )

66 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income Duff & Carson, Inc. Adjusted Trial Balance December 31, 20X1 Cash... Accounts receivable... Prepaid rent... Equipment... Accumulated depreciation... Accounts payable... Unearned service revenue... Interest payable... Salary payable... Income tax payable... Note payable... Common stock... Retained earnings, Dec. 31, 20X0... Dividends... Service revenue... Depreciation expense... Salary expense... Rent expense... Interest expense... Income tax expense... Total... $ 11,600 41,400 1,300 67,600 48,000 11,300 44,000 12,000 1,200 18,800 $257,200 $ 12,900 3,600 4,500 2, ,800 26,200 12,000 20, ,900 $257,200 P3-70B (Learning Objective 5: Making closing entries and evaluating retained earnings) The accounts of Cookie Lapp etravel, Inc., at December 31, 20X5, are listed in alphabetical order. Accounts payable... $ 5,100 Accounts receivable... 6,600 Accumulated depreciation furniture... 11,600 Advertising expense... 2,200 Cash... 7,300 Common stock... 15,000 Depreciation expense... 1,300 Dividends... 47,400 Furniture... 41,400 Interest expense Note payable, long-term... $10,600 Other assets... 3,600 Retained earnings, December 31, 20X4... 5,300 Salary expense... 24,600 Salary payable... 3,900 Service revenue... 93,500 Supplies... 7,700 Supplies expense... 5,700 Unearned service revenue... 3,600 Required 1. All adjustments have been journalized and posted, but the closing entries have not yet been made. Journalize Lapp s closing entries at December 31, 20X5. (p. 153) 2. Set up a T-account for Retained Earnings and post to that account. Then compute Lapp s net income for 20X5. What is the ending balance of Retained Earnings? (p. 159) 3. Did Retained Earnings increase or decrease during the year? What caused the increase or decrease? (p. 153)

67 29366_10_ch3_p /12/07 5:50 PM Page 191 Assess Your Progress 191 P3-71B (Learning Objective 4, 6: Preparing a classified balance sheet and using the ratios) Refer back to Problem 3-70B. 1. Use the Cookie Lapp etravel data in Problem 3-70B to prepare the company s classified balance sheet in report form at December 31, 20X5. Label total assets, total liabilities, and stockholders equity. (p. 153) 2. Compute Cookie Lapp s current ratio and debt ratio at December 31, 20X5. At December 31, 20X4, the current ratio was 1.50 and the debt ratio was Did Lapp s ability to pay both current and total liabilities improve or deteriorate during 20X5? (p. 159) P3-72B (Learning Objective 6: Analyzing financial ratios) This problem demonstrates the effects of transactions on the current ratio and the debt ratio of Rockwell Company. Rockwell s condensed balance sheet at March 31, 20X1, follows. (In millions) Total current assets... $3.0 Properties, net, and other assets $6.8 Total current liabilities... $2.2 Total long-term liabilities Total stockholders equity $6.8 During the following year, ending March 31, 20X2, Rockwell completed the following transactions: a. Paid half the current liabilities. b. Borrowed $3 million on long-term debt. c. Earned revenue of $2.5 million on account. d. Paid selling expense of $1 million. e. Accrued salary expense of $0.8 million. Credit Salary Payable, a current liability. f. Purchased equipment for $4.2 million, paying cash of $1.4 million and signing a longterm note payable for $2.8 million. g. Recorded depreciation expense of $0.6 million. Required 1. Compute Rockwell s current ratio and debt ratio at March 31, 20X1. Round to 2 decimal places. (p. 159) 2. Consider each transaction separately. Compute Rockwell s current ratio and debt ratio after each transaction during 20X2, that is, 7 times. Round ratios to 2 decimal places. (pp ) 3. Based on your analysis, you should be able to readily identify the effects of certain transactions on the current ratio and the debt ratio. Test your understanding by completing these statements with either increase or decrease : (pp ) a. Revenues usually the current ratio. b. Revenues usually the debt ratio. c. Expenses usually the current ratio. (Note: Depreciation is an exception to this rule.) d. Expenses usually the debt ratio. e. If a company s current ratio is greater than 1.0, as for Rockwell, paying off a current liability will always the current ratio. f. Borrowing money on long-term debt will always the current ratio and the debt ratio.

68 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income APPLY YOUR KNOWLEDGE Decision Cases Case 1. (Learning Objectives 3, 6: Adjusting and correcting the accounts; computing and evaluating the current ratio) The unadjusted trial balance of Good Times, Inc., at January 31, 20X6, does not balance. In addition, the trial balance needs to be adjusted before the financial statements at January 31, 20X6 can be prepared. The manager of Good Times needs to know the business s current ratio. Cash... $ 6,000 Accounts receivable... 2,200 Supplies Prepaid rent... 1,200 Land... 41,000 Accounts payable... 10,000 Salary payable... Unearned service revenue Note payable, due in 3 years... 25,400 Common stock... 5,000 Retained earnings... 7,300 Service revenue... 9,100 Salary expense... 3,400 Rent expense... Advertising expense Supplies expense... 0 Required 1. How much out of balance is the trial balance? The error is in the Land account. (pp ) 2. Good Times needs to make the following adjustments at January 31: a. Supplies of $600 were used during January. b. The balance of Prepaid Rent was paid on January 1 and covers the whole year 20X6. No adjustment was made on January 31. c. At January 31, Good Times owes employees $400. d. Unearned service revenue of $200 was earned during January. Prepare a corrected, adjusted trial balance. Give Land its correct balance. (pp ) 3. After the error is corrected and after these adjustments are made, compute the current ratio of Good Times, Inc. If your business had this current ratio, could you sleep at night? (p. 159) Case 2. (Learning Objectives 4: Preparing financial statements; continue or shut down the business?) On October 1, Tiger Woods opened Eagle Restaurant, Inc. Woods is now at a crossroads. The October financial statements paint a glowing picture of the business, and Woods has asked you whether he should expand the business. To expand the business, Woods wants to be earning net income of $10,000 per month and have total assets of $35,000. Woods believes he is meeting both goals. To start the business, Woods invested $20,000, not the $10,000 amount reported as Common stock on the balance sheet. The business issued $20,000 of common stock to Woods. The bookkeeper plugged the $10,000 Common stock amount into the balance sheet to make it balance. The bookkeeper made some other errors too. Woods shows you the following financial statements that the bookkeeper prepared.

69 29366_10_ch3_p /12/07 5:50 PM Page 193 Apply Your Knowledge 193 Required Prepare corrected financial statements for Eagle Restaurant, Inc.: Income Statement, Statement of Retained Earnings, and Balance Sheet. Then, based on Woods goals and your corrected statements, recommend to Woods whether he should expand the restaurant. (p. 147) Eagle Restaurant, Inc. Income Statement Month Ended October 31, 20X4 Revenues: Investments by owner... Unearned banquet sales revenue... Expenses: Wages expense... Rent expense... Dividends... Depreciation expense fixtures... Net income... $20,000 3,000 $ 5,000 4,000 3,000 1,000 $23,000 13,000 $10,000 Eagle Restaurant, Inc. Balance Sheet October 31, 20X4 Assets: Cash... Prepaid insurance... Insurance expense... Food inventory... Cost of goods sold (expense)... Fixtures (tables, chairs, etc.)... Dishes and silverware... $ 6,000 1,000 1,000 3,000 14,000 19,000 4,000 $48,000 Liabilities: Accounts payable... Sales revenue... Acuumulated depreciation fixtures... Owners equity: Common stock... $ 5,000 32,000 1,000 38,000 10,000 $48,000 Case 3. (Learning Objective 3, 4: Valuing a business on the basis of its net income) Sherwin Williams has owned and operated SW Advertising, Inc., since its beginning 10 years ago. Recently, Williams mentioned that he would consider selling the company for the right price. Assume that you are interested in buying this business. You obtain its most recent monthly trial balance, which follows. Revenues and expenses vary little from month to month, and June is a typical month. Your investigation reveals that the trial balance does not include the effects of monthly revenues of $5,000 and expenses totaling $1,100. If you were to buy SW Advertising, you would hire a manager so you could devote your time to other duties. Assume that your manager would require a monthly salary of $6,000.

70 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income SW Advertising, Inc. Trial Balance June 30, 20XX Cash... Accounts receivable... Prepaid expenses... Plant assets... Accumulated depreciation... Land... Accounts payable... Salary payable... Unearned advertising revenue... Common stock... Retained earnings... Dividends... Advertising revenue... Rent expense... Salary expense... Utilities expense... Depreciation expense... Supplies expense... Total... $ 10,000 4,900 3, , ,000 9,000 4, $305,000 $ 76,500 13,800 56,700 50,000 88,000 20,000 $305,000 Required 1. Assume that the most you would pay for the business is 20 times the amount of monthly net income you could expect to earn from it. Compute this possible price. (p. 147) 2. Williams states that the least he will take for the business is 1.5 times its stockholders equity on June 30. Compute this amount. (p. 147) 3. Under these conditions, how much should you offer Williams? Give your reason. (Challenge) Ethical Issues Issue 1. Cross Timbers Energy Co. is in its third year of operations, and the company has grown. To expand the business, Cross Timbers borrowed $1 million from Bank of Fort Worth. As a condition for making this loan, the bank required that Cross Timbers maintain a current ratio of at least 1.50 and a debt ratio of no more than Business recently has been worse than expected. Expenses have brought the current ratio down to 1.47 and the debt ratio up to 0.51 at December 15. Lane Collins, the general manager, is considering the result of reporting this current ratio to the bank. Collins is considering recording this year some revenue on account that Cross Timbers will earn next year. The contract for this job has been signed, and Cross Timbers will deliver the natural gas during January of next year. Required 1. Journalize the revenue transaction, and indicate how recording this revenue in December would affect the current ratio and the debt ratio. 2. State whether it is ethical to record the revenue transaction in December. Identify the accounting principle relevant to this situation. 3. Propose for Cross Timbers a course of action that is ethical.

71 29366_10_ch3_p /12/07 5:50 PM Page 195 Apply Your Knowledge 195 Issue 2. The net income of Accent Photography Company decreased sharply during Lisa Brown, owner of the company, anticipates the need for a bank loan in Late in 2009, Brown instructed the accountant to record a $20,000 sale of portraits to the Brown family, even though the photos will not be shot until January Brown also told the accountant not to make the following December 31, 2009, adjusting entries: Required Salaries owed to employees $5,000 Prepaid insurance that has expired.....1, Compute the overall effect of these transactions on the company s reported income for Is reported net income overstated or understated? 2. Why did Brown take these actions? Are they ethical? Give your reason, identifying the parties helped and the parties harmed by Brown s action. 3. As a personal friend, what advice would you give the accountant? Focus on Financials: YUM! Brands (Learning Objectives 3, 6: Tracing account balances to the financial statements) YUM! Brands, Inc. like all other businesses adjusts accounts prior to year end to get correct amounts for the financial statements. Examine YUM s balance sheet in Appendix A, and pay particular attention to (a) Prepaid Expenses and Other Current Assets and (b) Income Taxes Payable. Required 1. Why aren t Prepaid Expenses true expenses? Why does a company have income taxes payable at year end? (p. 132) 2. Open T-accounts for the two accounts listed above. Insert YUM s balances (in millions) at December 31, (p. 132) 3. Journalize the following transactions for the year ended December 30, Key entries by letter, and show amounts in millions. Explanations are not required. (pp ) a. Recorded General Expense for expiration of the beginning balance of Prepaid Expenses. b. Paid off the beginning balance of Income Taxes Payable. c. Paid the ending balance of Prepaid Expenses. d. Recorded Income Tax Expense of $284 million, paying $247 million in cash and accruing the remainder. 4. Post these entries to the 2 accounts and show that the ending balances of Prepaid Expenses and Other Current Assets and of Income Taxes Payable agree with the corresponding amounts reported in YUM s December 30, 2006, balance sheet. (pp ) 5. Compute the current ratios and debt ratios for YUM! Brands at December 31, 2005, and at December 30, Did the ratio values improve, deteriorate, or hold steady during 2006? Do YUM s ratio values indicate financial strength or weakness? (pp ) Focus on Analysis: Pier 1 Imports (Learning Objective 3: Explaining accruals and deferrals) During 2006, Pier I Imports had numerous accruals and deferrals. As a new member of Pier 1 s accounting staff, it is your job to explain the effects of accruals and deferrals on Pier 1 s net income for The accrual and deferral data follow, along with questions that Pier 1 stockholders have raised (all amounts in millions): 1. Beginning total receivables for 2006 were $47. Ending receivables for 2006 are $64. Which of these amounts did Pier 1 earn in 2005? Which amount did Pier 1 earn in 2006? Which amount is included in Pier 1 s net income for 2006? (pp ) 2. Accumulated depreciation stood at $383 at the end of 2005 and at $370 at year end Depreciation expense for 2006 was $56. How can accumulated depreciation decrease during 2006 when the company is adding more depreciation each year? (Challenge) (pp )

72 29366_10_ch3_p /12/07 5:50 PM Page Chapter 3 Accrual Accounting & Income 3. Pier 1 reports an account titled Gift Cards and other Deferred (Unearned) Revenue. This account carried credit balances of $61 at the end of 2005 and $64 at the end of What type of account is Gift Cards and other Deferred (Unearned) Revenue? Make a single journal entry to show how this account could have increased its balance during Then explain the event in your own words. (pp ) 4. Certain income-statement accounts are directly linked to specific balance-sheet accounts other than cash. Examine Pier 1 s income statement in Appendix B at the end of this book. For each Operating cost and expense, each Nonoperating (income) and expense, and Provision for income taxes, identify the related balance sheet account (other than cash). Use standard account titles, not necessarily the titles Pier 1 uses. (pp ) Group Project Matt Davis formed a lawn service company as a summer job. To start the business on May 1, he deposited $1,000 in a new bank account in the name of the corporation. The $1,000 consisted of an $800 loan from his father and $200 of his own money. The corporation issued 200 shares of common stock to Davis. Davis rented lawn equipment, purchased supplies, and hired high school students to mow and trim his customers lawns. At the end of each month, Davis mailed bills to his customers. On August 31, Davis was ready to dissolve the business and return to Duke University for the fall semester. Because he had been so busy, he had kept few records other than his checkbook and a list of amounts owed by customers. At August 31, Davis s checkbook shows a balance of $1,390, and his customers still owe him $560. During the summer, he collected $5,150 from customers. His checkbook lists payments for supplies totaling $400, and he still has gasoline, weedeater cord, and other supplies that cost a total of $50. He paid his employees wages of $1,900, and he still owes them $200 for the final week of the summer. Davis rented some equipment from Ludwig Tool Company. On May 1, he signed a 6- month lease on mowers and paid $600 for the full lease period. Ludwig will refund the unused portion of the prepayment if the equipment is in good shape. To get the refund, Davis has kept the mowers in excellent condition. In fact, he had to pay $300 to repair a mower that ran over a hidden tree stump. To transport employees and equipment to jobs, Davis used a trailer that he bought for $300. He figures that the summer s work used up one-third of the trailer s service potential. The business checkbook lists an expenditure of $460 for dividends paid to Davis during the summer. Also, Davis paid his father back during the summer. Required 1. Prepare the income statement of Davis Lawn Service, Inc., for the 4 months May through August. The business is not subject to income tax. 2. Prepare the classified balance sheet of Davis Lawn Service, Inc., at August 31. For Internet Exercises go to the Web site Quick Check Answers: 1. a 6. b 11. b 16. c 2. c 7. a 12. d 17. b 3. b 8. d 13. a 4. d 9. d 14. c 5. c 10. a 15. a

73 29366_ 1 _ch3demo_p /15/07 8:15 AM Page 197 Demo Doc Preparation of Adjusting Entries, Closing Entries, and Financial Statements Demo Doc: To make sure you understand this material, work through the following demonstration Demo Doc with detailed comments to help you see the concept within the framework of a workedthrough problem. Learning Objectives 2 5 Cloud Break Consulting, Inc., has the following information at June 30, 2008: CLOUD BREAK CONSULTING, INC. Unadjusted Trial Balance June 30, 2008 Account Title Cash Accounts receivable Supplies Prepaid rent Land Building Accumulated depreciation building Accounts payable Unearned service revenue Common stock Retained earnings Dividends Service revenue Salary expense Rent expense Miscellaneous expense Total Balance Debit Credit $131, ,000 4,000 27,000 45, ,000 $155, ,000 40,000 50,000 52,000 7, , ,000 25,000 8,000 $906,000 $906,000 June 30 is Cloud Break s fiscal year end; accordingly, it must make adjusting entries for the following items: a. Supplies on hand at year-end, $1,000. b. Nine months of rent totaling $27,000 were paid in advance on April 1, Cloud Break has recorded no rent expense yet. c. Depreciation expense has not been recorded on the building for the 2008 fiscal year. The building has a useful life of 25 years. d. Employees work Monday through Friday. The weekly payroll is $5,000 and is paid every Friday. June 30, 2008, falls on a Thursday. (continued) Demo Doc 197

74 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 198 e. Service revenue of $15,000 must be accrued. f. Cloud Break received $40,000 in advance for consulting services to be provided evenly from January 1, 2008 through August 31, Cloud Break has recorded none of this revenue. Requirements 1. Open the T-accounts with their unadjusted balances. 2. Journalize Cloud Break s adjusting entries at June 30, 2008, and post the entries to the T-accounts. 3. Total each T-account in the ledger. 4. Journalize and post Cloud Break s closing entries. 5. Prepare Cloud Break s income statement and statement of retained earnings for the year ended June 30, 2008, and the balance sheet at June 30, Draw arrows linking the 3 financial statements. 198 Chapter 3 Accrual Accounting & Income

75 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 199 Demo Doc Solutions Requirement 1 Open the T-accounts with their unadjusted balances. Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete Remember from Chapter 2 that opening a T-account means drawing a blank account that looks like a capital T and putting the account title across the top. To help find the accounts later, they are grouped into assets, liabilities, stockholders equity, revenues, and expenses (in that order). If the account has a starting balance, it must appear on the correct side. Remember that debits are always on the left side of the T-account and credits are always on the right side. This is true for every account. The correct side to enter each account s starting balance is the side of increase in the account. This is because we expect all accounts to have a positive balance (that is, more increases than decreases). For assets, an increase is a debit, so we would expect all assets (except contra assets such as Accumulated Depreciation) to have a debit balance. For liabilities and stockholders equity, an increase is a credit, so we would expect all liabilities and equities (except Dividends) to have a credit balance. By the same reasoning, we expect revenues to have credit balances and expenses and dividends to have debit balances. The unadjusted balances appearing in the T-accounts are simply the amounts from the starting trial balance. ASSETS STOCKHOLDERS EQUITY EXPENSES Cash Building Common Stock Salary Expense 131, ,000 50, ,000 Accounts Receivable Accumulated Depreciation Building Retained Earnings Rent Expense 104, ,000 52,000 25,000 Supplies 4,000 Prepaid Rent 27,000 Land LIABILITIES Accounts Payable 159,000 Unearned Service Revenue 40,000 Dividends 7,000 REVENUE Service Revenue 450,000 Miscellaneous Expense 8,000 45,000 Demo Doc Solutions 199

76 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 200 Requirement 2 Journalize Cloud Break s adjusting entries at June 30, 2008, and post the entries to the T-accounts. Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete a. Supplies on hand at year end, $1,000. On June 30, 2008, the unadjusted balance in the Supplies account was $4,000. However, a count shows that only $1,000 of supplies actually remains on hand. The supplies that are no longer there have been used. When assets/benefits are used, an expense is created. Cloud Break will need to make an adjusting journal entry in order to report the correct amount of supplies on the balance sheet. Looking at the Supplies T-account: Supplies 4,000 Used up 1,000 X The supplies have decreased because they have been used up. The amount of the decrease is X. X = $4,000 $1,000 = $3,000. $3,000 of supplies expense must be recorded to show the value of supplies that have been used. a. June 30 Supplies Expense ($4,000 $1,000) (Expense ; debit) 3,000 Supplies (Asset ; credit) 3,000 To record supplies expense. After posting, Supplies and Supplies Expense hold their correct ending balances: ASSETS Supplies EXPENSES Supplies Expense 4,000 1,000 a. 3,000 a. 3,000 3,000 b. Nine months of rent (totalling $27,000) were paid in advance on April 1, Cloud Break has recorded no rent expense yet. A prepayment for something, such as for rent or insurance, creates a future benefit (an asset) because the business is now entitled to receive the prepaid goods or services. Once those 200 Chapter 3 Accrual Accounting & Income

77 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 201 goods or services are received (in this case, once Cloud Break has occupied the building being rented), the benefit expires, and the prepaid cost becomes an expense. Cloud Break prepaid $27,000 for 9 months of rent on April 1. This means that Cloud Break pays $27,000/9 = $3,000 a month for rent. At June 30, Prepaid Rent is adjusted for the amount of the asset that has been used up. Because Cloud Break has occupied the building being rented for 3 months (April, May, and June), 3 months of the prepayment have been used. The amount of rent used is 3 $3,000 = $9,000. Because that portion of the past benefit (asset) has expired, it becomes an expense (in this case, the adjustment transfers $9,000 from Prepaid Rent to Rent Expense). This means that Rent Expense must be increased (a debit) and Prepaid Rent (an asset) must be decreased (a credit), with the following journal entry: b. June 30 Rent Expense (Expense ; debit) Prepaid Rent (Asset ; credit) To record rent expense. 9,000 9,000 Posting places $9,000 in each account, as follows: ASSETS Prepaid Rent 27,000 b. 9,000 18,000 25,000 b. 9,000 34,000 EXPENSES Rent Expense c. Depreciation expense has not been recorded on the building for the 2008 fiscal year. The building has a useful life of 25 years. Depreciation expense per year is calculated as: Original cost of asset Depreciation expense per year = Useful life of asset (in years) The cost principle compels us to keep the original cost of a plant asset in that asset account. Because there is $300,000 in the Building account, we know that this is the original cost of the building. We are told in the question that the building s useful life is 25 years. Depreciation expense per year = $300,000/25 years = $12,000 per year We will record depreciation of $12,000 in an adjusting journal entry. The journal entry for depreciation expense is always the same. Only the dollar amount changes. There is always an increase to Depreciation Expense (a debit) and an increase to the contra-asset account of Accumulated Depreciation (a credit). Demo Doc Solutions 201

78 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 202 c. June 30 Depreciation Expense Building (Expense ; debit) Accumulated Depreciation Building 12,000 (Contra Asset ; credit) 12,000 To record depreciation on building. ASSETS EXPENSES ASSET Building 300, ,000 CONTRA ASSET Accumulated Depreciation Building 155,000 c. 12, ,000 Depreciation Expense Building c. 12,000 12,000 The book value of the building is its original cost (the amount in the Building T-account) minus the accumulated depreciation on the building. Book value of plant assets: Building... $300,000 Less: Accumulated depreciation... (167,000) Book value of the building... $133,000 d. Employees work Monday through Friday. The weekly payroll is $5,000 and is paid every Friday. June 30, 2008, falls on a Thursday. Salary is an accrued expense. That is, it s a liability that comes from an expense that hasn t been paid yet. Most employers pay their employees after the work has been done, so the work is a past benefit to the employer. This expense (Salary Expense, in this case) grows until payday. Cloud Break s employees are paid $5,000 for 5 days of work. That means they earn $5,000/5 = $1,000 per day. By the end of the day on Thursday, June 30, they have earned $1,000/day 4 days = $4,000 of salary. If the salaries have not been paid, then they are payable (or in other words, they are owed) and must be recorded as some kind of payable account. You might be tempted to use Accounts Payable, but this account is usually reserved for bills received. But employees don t bill employers for their paychecks. The appropriate payable account for salaries is Salary Payable. The accrual of salary expense creates an increase to Salary Expense (a debit) and an increase to the liability Salary Payable (a credit) of $4,000. d. June 30 Salary Expense (Expense ; debit) 4,000 Salary Payable (Liability ; credit) 4,000 To accrue salary expense. 202 Chapter 3 Accrual Accounting & Income

79 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page ,000 d. 4, ,000 EXPENSES Salary Expense LIABILITIES Salary Payable d. 4,000 4,000 e. Service revenue of $15,000 must be accrued. Accrued revenue is another way of saying accounts receivable (or receipt in the future). When accrued revenue is recorded, it means that accounts receivable are also recorded (that is, the business gave goods or services to customers, but the business has not yet received the cash). The business is entitled to these receivables because the revenue has been earned. Service Revenue must be increased by $15,000 (a credit) and the Accounts Receivable asset must be increased by $15,000 (a debit). e. June 30 Accounts Receivable (Asset ; debit) Service Revenue (Revenue ; credit) To accrue service revenue. 15,000 15,000 ASSETS Accounts Receivable 104,000 e. 15, ,000 REVENUES Service Revenue 450,000 e. 15, ,000 f. Cloud Break received $40,000 in advance for consulting services to be provided evenly from January 1, 2008, through August 31, Cloud Break has recorded none of this revenue. Cloud Break received cash in advance for work to be performed in the future. By accepting the cash, Cloud Break also accepted the obligation to perform that work (or provide a refund). In accounting, an obligation is a liability. We call this liability unearned revenue because it will be revenue (after the work is performed) but it is not revenue yet. The $40,000 collected in advance is still in the Unearned Service Revenue account. However, some of the revenue has been earned as of June 30. Six months of the earnings period have passed (January through June), so Cloud Break has earned 6 months of the revenue. The entire revenue-earning period is 8 months ( January through August), so the revenue earned per month is $40,000/8 = $5,000. The 6 months of revenue that Cloud Break has earned through the end of June totals $30,000 (6 $5,000). Demo Doc Solutions 203

80 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 204 So Unearned Service Revenue, a liability, must be decreased by $30,000 (a debit). Because that portion of the revenue is now earned, Service Revenue is increased by $30,000 (a credit). f. June 30 Unearned Service Revenue (Liability ; debit) 30,000 Service Revenue (Revenue ; credit) 30,000 To record the earning of service revenue that was collected in advance. Essentially, the $30,000 has been shifted from unearned revenue to earned revenue. LIABILITIES Unearned Service Revenue REVENUES Service Revenue f. 30,000 40,000 10, ,000 e. 15,000 f. 30, ,000 Now we can summarize all of the adjusting journal entries: Ref. Date Accounts and Explanation Debit Credit 2008 a. June 30 Supplies Expense ($4,000 $1,000) Supplies To record supplies expense. 3,000 3,000 b. 30 Rent Expense 9,000 Prepaid Rent 9,000 To record rent expense. c. 30 Depreciation Expense Building 12,000 Accumulated Depreciation Building 12,000 To record depreciation on building. d. 30 Salary Expense 4,000 Salary Payable 4,000 To accrue salary expense. e. 30 Accounts Receivable 15,000 Service Revenue 15,000 To accrue service revenue. f. 30 Unearned Service Revenue 30,000 Service Revenue 30,000 To record the earning of service revenue that was collected in advance. 204 Chapter 3 Accrual Accounting & Income

81 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 205 Requirement 3 Total each T-account in the ledger. Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete After posting all of these entries and totaling all of the T-accounts, we have: 131,000 Cash Accounts Receivable 104,000 e. 15, ,000 Supplies 4,000 1,000 45,000 Prepaid Rent 27,000 18,000 Land a. 3,000 b. 9,000 ASSETS 300,000 Building Accumulated Depreciation Building LIABILITIES 155,000 c. 12, ,000 Accounts Payable 159,000 Salary Payable d. 4,000 4,000 Unearned Service Revenue f. 30,000 40,000 10,000 STOCKHOLDERS EQUITY Common Stock 50,000 Retained Earnings 7,000 Dividends REVENUE 52,000 Service Revenue 450,000 e. 15,000 f. 30, ,000 EXPENSES Salary Expense 255,000 d. 4, ,000 Supplies Expense a. 3,000 3,000 Rent Expense 25,000 b. 9,000 34,000 Depreciation Expense Building c. 12,000 12,000 Miscellaneous Expense 8,000 Requirement 4 Journalize and post Cloud Break s closing entries. Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete We prepare closing entries to (1) clear out the revenue, expense, and dividends accounts to a zero balance in order to get them ready for the next period. They must begin the next period Demo Doc Solutions 205

82 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 206 empty so that we can evaluate each period s income separately from all other periods. We also need to (2) update the Retained Earnings account by transferring all revenues, expenses, and dividends into it. The Retained Earnings balance is calculated each year using the following formula: Beginning retained earnings + Net income (or Net loss) Dividends declared = Ending retained earnings You can see this in the Retained Earnings T-account as well: Retained Earnings Beginning retained earnings Net income Dividends Ending retained earnings This formula is the key to preparing the closing entries. We will use this formula, but we will do it inside the Retained Earnings T-account. From the trial balance given in the problem, we know that beginning Retained Earnings is $52,000. The first component of the formula is already in the T-account. The next component is net income, which is not yet in the Retained Earnings account. There is no T-account with net income in it, but we can place all the components of net income into the Retained Earnings account and come out with the net income number at the bottom. Remember: Revenues Expenses = Net income This means that we need to get all of the revenues and expenses into the Retained Earnings account. We start with our revenue T-account: Service Revenue 495, Chapter 3 Accrual Accounting & Income

83 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 207 In order to clear out all the income statement accounts so that they are empty to begin the next year, the first step is to debit each revenue account for the amount of its credit balance. Service Revenue has a credit balance of $495,000, so to bring that to zero, we need to debit Service Revenue for $495,000. This means that we have part of our first closing entry: 1. Service Revenue??? 495, ,000 What is the credit side of this entry? The reason we started with Service Revenue was to help calculate net income in the Retained Earnings account. So the other side of the entry must go to Retained Earnings: 1. Service Revenue Retained Earnings 495, ,000 Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete The second step is to credit each expense account for the amount of its debit balance to bring each expense account to zero. In this case, we have 5 different expenses: 259,000 Salary Expense 3,000 Supplies Expense 34,000 Rent Expense Depreciation Expense Building 12,000 Miscellaneous Expense 8,000 The sum of all the expenses will go to the debit side of the Retained Earnings account: 2. Retained Earnings Salary Expense Supplies Expense Rent Expense Depreciation Expense Building Miscellaneous Expense 316, ,000 3,000 34,000 12,000 8,000 Demo Doc Solutions 207

84 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 208 Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete The last component of the Retained Earnings formula is dividends. There is a Dividends account: 7,000 Dividends The final step in the closing process is to transfer Dividends to the debit side of the Retained Earnings account. The Dividends account has a debit balance of $7,000, so to bring that to zero, we need to credit Dividends by $7,000. The balancing debit will go to Retained Earnings: 3. Retained Earnings Dividends 7,000 7,000 This entry subtracts Dividends from Retained Earnings. Retained Earnings now holds the following data: Expenses ,000 Dividends 3. 7,000 Retained Earnings 52,000 Beginning retained earnings ,000 Revenue Net income 224,000 Ending retained earnings The formula to update Retained Earnings has now been re-created inside the Retained Earnings T-account. 208 Chapter 3 Accrual Accounting & Income

85 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 209 The following accounts are included in the closing process: 1 Service Revenue , ,000 0 Salary Expense 259, ,000 0 Supplies Expense 3, ,000 0 Rent Expense 34, , , ,000 Dividends 7, ,000 Retained Earnings 52, , , Depreciation Expense Building 12, ,000 0 Miscellaneous Expense 8, ,000 0 Notice that each temporary account (the revenues, the expenses, and Dividends), now has a zero balance. Requirement 5 Prepare Cloud Break s income statement and the statement of retained earnings for the year ended June 30, 2008, and the balance sheet at June 30, Draw arrows linking the 3 financial statements. Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete Demo Doc Solutions 209

86 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 210 CLOUD BREAK CONSULTING, INC. Income Statement Year Ended June 30, 2008 Revenue: Service revenue Expenses: Salary expense Rent expense Depreciation expense building Supplies expense Miscellaneous expense Total expenses Net income $259,000 34,000 12,000 3,000 8,000 $495, ,000 $179,000 CLOUD BREAK CONSULTING, INC. Statement of Retained Earnings Year Ended June 30, 2008 Retained earnings, June 30, 2007 Add: Net income Less: Dividends Retained earnings, June 30, 2008 $ 52, , ,000 (7,000) $224,000 Assets Liabilities Cash $131,000 Accounts payable $159,000 Accounts receivable Supplies Prepaid rent Land Building Less: Accumulated Total assets depreciation CLOUD BREAK CONSULTING, INC. Balance Sheet June 30, 2008 $300,000) (167,000) 119,000 1,000 18,000 45, ,000 $447,000 Salary payable Unearned service revenue Total liabilities Stockholders Equity Common stock Retained earnings Total stockholders equity Total liabilities and stockholders equity 4,000 10, ,000 50, , ,000 $447, Chapter 3 Accrual Accounting & Income

87 29366_ 2934x_06_ch3demo_p /15/07 8:15 AM Page 211 RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS The arrows in these statements show how the financial statements relate to each other. Follow the arrow that takes the ending balance of Retained Earnings to the balance sheet. 1. Net income from the income statements is reported as an increase to Retained Earnings on the statement of retained earnings. A net loss would be reported as a decrease to Retained Earnings. 2. Ending Retained Earnings from the statement of retained earnings is transferred to the balance sheet. The ending Retained Earnings is the final balancing amount for the balance sheet. Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Demo Doc Complete Demo Doc Solutions 211

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89 29366_12_03TP_pa-b 12/14/07 3:41 PM Page a Chapter 3 Special Section

90 29366_12_03TP_pa-b 12/14/07 3:41 PM Page b

91 29366_13_03SS_p /14/07 3:41 PM Page 1 Chapter 3 Special Section In This Section Topic and Resources Page Learning Objectives Demo Doc 1: Adjusting Entries for Accrual Accounting 1 6 Sample Question (copy and hand out to class) Special Section 3 4 Answer & Explanation (for use as instructor class notes) Special Section 5 16 Suggested Homework Problems Special Section 17 Textbook Example: Adjusting Entries P3-66B Special Section Teaching Tips 1 Emphasize that you can t judge an account name by its cover. Prepaid expenses are assets, not expenses. Unearned revenue is a liability, not a revenue. Students often assume the wrong account type, but they need to understand that they must look at the meaning of the entire name, not just the revenue/expense portion. 2 For the concepts of prepaid and accrued expenses, tie the discussion back to the past/future benefits concepts introduced in Chapter 1. A future benefit is an asset; a past benefit is an expense. This will help students determine what kind of account to use in the adjusting entry. 3 When preparing the trial balance, you should emphasize that the amount in the Retained Earnings account is last period s ending balance that has been carried forward, because nothing has been done to this account this year so far. Students are often confused and think that the Retained Earnings amount on the trial balance is the same amount that goes on the balance sheet. Illustrate the difference when you prepare the statement of Retained Earnings. 4 When making adjusting entries, it is sometimes necessary to count months (see, for example, Requirement 2e of Demo Doc 1). Although this sounds simple, it is very easy for students to make a mistake. For example, January 31 through March 31 is two months, but so are April 1 through May 31 and June 30 through September 1. Encourage students to check the dates carefully and, if necessary, count on their fingers to make sure they get the number of months right. 5 Many students feel that they have to memorize the closing entries. Try to illustrate the connection between the retained earnings formula/statement of retained earnings and the entries. If the students can recreate this formula, they do not need to memorize the entry structure and they will have a better understanding of the topic. Instructor s Edition Special Section Page 1 Chapter 3

92 29366_13_03SS_p /14/07 3:41 PM Page 2 6 Be sure to point out that while balance sheet accounts carry the balance forward to the next year, the income statement and Dividends accounts do not. This is because the income statement and statement of Retained Earnings cover a period of time and each period begins with nothing in the accounts. The other purpose of closing entries (besides updating the Retained Earnings account) is to zero out these temporary accounts in preparation for the next year. Chapter 3 Instructor s Edition Special Section Page 2

93 29366_13_03SS_p /14/07 3:41 PM Page 3 Demo Doc 1 Adjusting Entries for Accrual Accounting Carson Apartments rents housing units to college students. Carson s December 31 (year-end) trial balance (before adjustments) is as follows: Carson Apartments Company Trial Balance Year Ended December 31, 2009 Account Title Debit Balance Credit Cash... Interest receivable... Prepaid insurance... Supplies... Apartment building... Accumulated depreciation building... Accounts payable... Salary payable... Unearned rent revenue... Common stock... Retained earnings... Dividends... Rent revenue... Interest revenue... Salary expense... Insurance expense... Supplies expense... Depreciation expense... Total... $ 33, , ,000 9,000 16,500 2, $164,250 $ 25,000 2, ,000 25,000 50,000 55, $164,250 Requirements 1. Open the T-accounts and enter their unadjusted balances. 2. Journalize the following adjusting entries at December 31, Key the entries by letter. a. Only $2,000 of the unearned rent revenue remains unearned. b. Depreciation on the apartment building is $5,000 for the year. c. Employees earned salaries of $1,500 that have not been paid. d. Supplies worth $400 have been used. Instructor s Edition Special Section Page 3 Chapter 3

94 29366_13_03SS_p /14/07 3:41 PM Page 4 e. On September 30, 2009, $1,000 of insurance costs were prepaid for the next four months of coverage. f. Carson earns $100 of interest revenue per month. Interest revenue was last collected (received) on September 30, Post the adjusting entries. 4. Would any of these entries be made under the cash basis of accounting? Why or why not? 5. Write the trial balance on a work sheet, enter the adjusting entries, and prepare an adjusted trial balance. 6. Prepare the income statement, statement of retained earnings, and balance sheet for Carson Apartments. 7. Journalize and post the closing entries. 8. Calculate Carson s current and debt ratios. Chapter 3 Instructor s Edition Special Section Page 4

95 29366_13_03SS_p /14/07 3:41 PM Page 5 Demo Doc 1 Solutions Requirement 1 Open the T-accounts and enter their unadjusted balances. ASSETS LIABILITIES REVENUES 33,550 Cash Interest Receivable Prepaid Insurance 1, Supplies Apartment Building 100,000 Accumulated Depreciation Building 25,000 Accounts Payable 2,350 Salary Payable Unearned Rent Revenue 6,000 STOCKHOLDERS EQUITY Common Stock 25,000 Retained Earnings 50,000 Dividends 9,000 Rent Revenue 55,000 Interest Revenue 900 EXPENSES Insurance Expense 2,675 Salary Expense 16,500 Depreciation Expense Supplies Expense 625 Instructor s Edition Special Section Page 5 Chapter 3

96 29366_13_03SS_p /14/07 3:41 PM Page 6 Requirement 2 Journalize the following adjusting entries at December 31, Key the entries by letter. a. Only $2,000 of the unearned rent revenue remains unearned. a. Unearned Rent Revenue ($6,000 $2,000) Rent Revenue To record rent revenue collected in advance. 4,000 4,000 Teaching Tip 1 Before adjustments, the Unearned Rent Revenue account (a liability) has a balance of $6,000. Only $2,000 of that is still unearned. This means that the other $6,000 $2,000 = $4,000 has been earned. If it has been earned, we need to take the $4,000 out of the unearned Revenue account (a liability) and put it into the earned revenue account, which in this case is Rent Revenue. So we must decrease the Unearned Rent Revenue liability (a debit) and increase Rent Revenue (a credit). b. Depreciation on the apartment building is $5,000 for the year. b. Depreciation Expense Accumulated Depreciation, Building To record depreciation expense. 5,000 5,000 The entry to record depreciation expense is always the same. It is only the number (that is, the dollar amount) in the entry that changes. There is always an increase to Depreciation Expense (a debit) and an increase to the contra-asset account of Accumulated Depreciation (a credit). We increase accumulated depreciation instead of decreasing the building asset in order to satisfy the requirements of the cost principle. The Building account must reflect its original cost. If we combine the Building account balance (a debit) and the Accumulated Depreciation account balance (a credit), then we get the net value of the building, which is a reflection of its remaining value/benefit. We are given the depreciation expense of $5,000, so we simply write the entry with that amount. Chapter 3 Instructor s Edition Special Section Page 6

97 29366_13_03SS_p /14/07 3:41 PM Page 7 c. Employees earned salaries of $1,500 that have not been paid. c. Salary Expense Salary Payable To accrue salary expense. 1,500 1,500 Teaching Tip 2 If the salaries have not been paid, then they are payable (or, in other words, they are owed). This means that they must be recorded as some kind of payable account. Normally, we might consider using Accounts Payable, but this account is usually reserved for bills received, but not paid. The employees do not send Carson a bill. They simply expect to be paid and Carson knows that the salaries are owed. So we put this into another payable account. In this case, Salary Payable is most appropriate. Because salary is not owed until work is performed, we know that Carson s employees have already worked. This is a past benefit, which means that we need to record an expense (in this case, Salary Expense). There is an increase to Salary Expense (a debit) and an increase to the liability Salary Payable (a credit) of $1,500. d. Supplies worth $400 have been used. d. Supplies Expense Supplies To record supplies used Teaching Tip 2 Supplies are an asset: a future benefit to Carson. Once the supplies are used, they are a past benefit. Supplies used are no longer assets, so the Supplies asset must be decreased by $400 (a credit) to reflect the actual amount on hand. Past benefits are expenses, so Supplies Expense must be increased (a debit). e. On September 30, 2009, $1,000 of insurance costs were prepaid for the next four months of coverage. e. Insurance Expense (3 $250) Prepaid Insurance To record insurance expense Teaching Tip 2 When something is prepaid, it is a future benefit (an asset) because the business is now entitled to receive goods or services. Instructor s Edition Special Section Page 7 Chapter 3

98 29366_13_03SS_p /14/07 3:41 PM Page 8 Teaching Tip 4 Once those goods or services are received, this becomes a past benefit and, therefore, an expense. Insurance Expense must be increased (a debit) and the Prepaid Insurance asset must be decreased (a credit) because the benefit of the prepayment has been used. $1,000 is for four months of coverage (the benefit period). Each month costs $1,000/4 = $250. At December 31, three months have passed since the payment was made. Three months of insurance expense must be recorded: $250 3 = $750 Alternatively: One month remains in Prepaid Insurance. $250 1 = $250, so the ending balance must be adjusted to $250. The balance is now $1,000, so a $750 adjustment must be made ($1,000 $750 = $250 ending balance). Insurance Expense must be increased (a debit) and the Prepaid Insurance asset must be decreased (a credit). f. Carson earns $100 of interest revenue per month. Interest revenue was last collected (received) on September 30, f. Interest Receivable (3 $100) Interest Revenue To record interest revenue earned Since September 30, three months have passed (October, November, and December). This means that interest revenue has not been recorded for three months. We need to increase (a credit) Interest Revenue for: 3 $100 = $300 Because this interest revenue has not yet been collected, it is interest receivable (that is, Carson will receive it in the future). Chapter 3 Instructor s Edition Special Section Page 8

99 29366_13_03SS_p /14/07 3:41 PM Page 9 Interest Receivable (an asset) is increased (a debit) by $300. Requirement 3 Post the adjusting entries. ASSETS LIABILITIES REVENUES 33,550 f. Cash Interest Receivable Prepaid Insurance 1, Supplies Apartment Building 100,000 e. 750 d. 400 Accumulated Depreciation Building b. 25,000 5,000 30,000 Accounts Payable a. 4,000 Salary Payable Common Stock 2,350 STOCKHOLDERS EQUITY 25,000 Retained Earnings 9,000 c. Unearned Rent Dividends 1,500 1,500 6,000 2,000 50,000 e. c. b. Rent Revenue Interest Revenue EXPENSES Insurance Expense 2, ,425 Salary Expense 16,500 1,500 18,000 a. f. Depreciation Expense 5,000 5,500 Supplies Expense 55,000 4,000 59, ,200 d ,025 Requirement 4 Would any of these entries be made under the cash basis of accounting? Why or why not? Cash-basis accounting only records a journal entry when cash is involved. This means that there must be a line for cash in the journal entry in order for it to be recorded under the cash basis of accounting. Because none of these adjusting entries deal with cash, none of them are relevant (that is, none of them would be recorded) under the cash basis of accounting. Instructor s Edition Special Section Page 9 Chapter 3

100 29366_13_03SS_p /14/07 3:41 PM Page 10 Requirement 5 Teaching Tip 3 Write the trial balance on a work sheet, enter the adjusting entries, and prepare an adjusted trial balance. Carson Apartments Company Preparation of Adjusted Trial Balance December 31, 2009 Account Title Trial Balance Debit Credit Debit Adjustments Credit Adjusted Trial Balance Debit Credit Cash... Interest Receivable... Prepaid Insurance... Supplies... Apartment Building... Accumulated Depreciation Building... Accounts Payable... Salary Payable... Unearned Rent Revenue... Common Stock... Retained Earnings... Dividends... Rent Revenue... Interest Revenue... Insurance Expense... Salary Expense... Depreciation Expense... Supplies Expense... Total... 33, , ,000 9,000 2,675 16, $164,250 25,000 2, ,000 25,000 50,000 55, $164,250 (f) 300 (a) 4,000 (e) 750 (c) 1,500 (b) 5,000 (d) 400 $11,950 (e) 750 (d) 400 (b) 5,000 (c) 1,500 (a) 4,000 (f) 300 $11,950 33, ,000 9,000 3,425 18,000 5,000 1,025 $171,050 30,000 2,350 1,500 2,000 25,000 50,000 59,000 1,200 $171,050 Chapter 3 Instructor s Edition Special Section Page 10

101 29366_13_03SS_p /14/07 3:41 PM Page 11 Requirement 6 Prepare the income statement, statement of retained earnings, and balance sheet for Carson Apartments. Carson Apartments Company Income Statement Year Ended December 31, 2009 Revenue: Rent revenue... Interest revenue... Total revenues... $59,000 1,200 60,200 Expenses: Insurance expense... Salary expense... Depreciation expense... Supplies expense... Total expenses... $ 3,425 18,000 5,000 1,025 27,450 Net income... $32,750 Teaching Tip 3 The one account that has not yet been updated is Retained Earnings. The $50,000 in this account is the amount from the beginning of the year (January 1). To update the account, we need to prepare the statement of retained earnings. Carson Apartments Company Statement of Retained Earnings Year Ended December 31, 2009 Retained earnings, January 1, Add: Net income for year... $50,000 32,750 82,750 Less: Dividends... Retained earnings, December 31, (9,000) $73,750 Instructor s Edition Special Section Page 11 Chapter 3

102 29366_13_03SS_p /14/07 3:41 PM Page 12 Use this updated Retained Earnings amount on the balance sheet. Carson Apartments Company Balance Sheet December 31, 2009 Assets Liabilities Cash... Interest receivable... Prepaid insurance... Supplies... Building... Less: Accumulated depreciation... Total assets... $100,000 (30,000) $ 33, ,000 $104,600 Accounts payable... Salary payable... Unearned revenue... Total liabilities... Equity Common stock... Retained earnings... Total liabilities and equity... $ 2,350 1,500 2,000 5,850 $ 25,000 73,750 $104,600 Requirement 7 Journalize and post the closing entries. 1. Rent Revenue Interest Revenue Retained Earnings 59,000 1,200 60, Retained Earnings Insurance Expense Salary Expense Depreciation Expense Supplies Expense 27,450 3,425 18,000 5,000 1, Retained Earnings Dividends 9,000 9,000 Chapter 3 Instructor s Edition Special Section Page 12

103 29366_13_03SS_p /14/07 3:41 PM Page 13 Rent Revenue Dividends 1. 59,000 59, , ,000 Interest Revenue Retained Earnings 1, ,200 0 Insurance Expense ,450 9, ,000 60,200 73,750 3, ,425 Salary Expense 18, ,000 Depreciation Expense 5, ,000 Supplies Expense 1, ,025 Teaching Tip 5 There are two reasons to prepare closing entries. First, we need to clear out the revenue and expense accounts to a zero balance because they need to begin the next year empty. Second, we need to update the Retained Earnings account. From Chapter 1: Beginning retained earnings + Net income Dividends Ending retained earnings Instructor s Edition Special Section Page 13 Chapter 3

104 29366_13_03SS_p /14/07 3:41 PM Page 14 We will use this formula for closing entries, but we will do it inside the Retained Earnings T-account: Retained Earnings Dividends Beginning Retained Earnings Revenues Net Income Ending Retained Earnings Teaching Tip 5 The Retained Earnings account has a balance of $50,000. This is the ending balance from last year. The first component of the formula (beginning retained earnings) is already in the T-account. The next component is net income, which is not already in the Retained Earnings account. Net income needs to be added to the Retained Earnings account. We will place all the components of net income into Retained Earnings and come out with a total for net income or net loss. From Chapter 1, remember the formula for net income: Revenues Expenses = Net income So we need to get all of the revenues and expenses into the Retained Earnings account. Look at the Rent Revenue and Interest Revenue T-accounts: Rent Revenue 59,000 Interest Revenue 1,200 Teaching Tip 6 Remember, we need to clear out the income statement accounts so that they can be empty to begin the next year. We also need to combine the revenues with the expenses for the period to get net income (or net loss). Rent Revenue has a credit balance of $59,000, so to bring that to zero, we need to debit $59,000. Interest Revenue has a credit balance of $1,200, so to bring that to zero, we need to debit $1,200. Chapter 3 Instructor s Edition Special Section Page 14

105 29366_13_03SS_p /14/07 3:41 PM Page 15 The part of our first closing entry is: 1. Rent Revenue Interest Revenue??? 59,000 1,200 60,200 The other (credit) side of the entry must go to the Retained Earnings. Teaching Tip 5 The next part of net income is the expenses. In this case, we have four different expenses: Insurance Expense Depreciation Expense 3,425 5,000 Salary Expense Supplies Expense 18,000 1,025 Each of these expenses has a debit balance. Teaching Tip 6 Teaching Tip 5 In order to bring these accounts to zero, we must credit them. The balancing debit will go to the Retained Earnings account. The last component of the Retained Earnings account formula is dividends. There is already a Dividends account that exists. 9,000 Dividends Teaching Tip 6 Dividends has a debit balance of $9,000, so to bring that to zero, we need to credit $9,000. The balancing debit will go to the Retained Earnings account to reduce the equity. Instructor s Edition Special Section Page 15 Chapter 3

106 29366_13_03SS_p /14/07 3:41 PM Page 16 The Retained Earnings account now has the following transactions: Retained Earnings Expenses Dividends ,450 9, ,000 60,200 73,750 Beginning Retained Earnings Revenue Net Income Ending Retained Earnings Teaching Tip 5 The formula to update the Retained Earnings amount has been recreated inside the Retained Earnings T-account. In summary, there are three closing entries that must be completed in order: Close revenues to Retained Earnings. Close expenses to Retained Earnings. Close Dividends to the Retained Earnings account. Requirement 8 Calculate Carson s current and debt ratios. Current ratio = Current assets Current liabilities = $34,600 $5,850 = 5.91 Debt ratio = Total liabilities Total assets $5,850 + $0 = $34,600 + $70,000 = $5,850 $104,600 = 5.59% Chapter 3 Instructor s Edition Special Section Page 16

107 29366_13_03SS_p /14/07 3:41 PM Page 17 Suggested Homework Problems E3-18, E3-20, E3-21, E3-22, E3-23, E3-24, E3-29, E3-34 P3-56A, P3-57A, P3-58A, P3-60A, P3-61A, P3-62A P3-66B, P3-67B, P3-68B, P3-70B, P3-71B, P3-72B Decision Case 1 (Chapter 3), Ethical Issue 1 (Chapter 3), Ethical Issue 2 (Chapter 3) Textbook Example: Adjusting Entries (P3-66B p. 187) Journalize the adjusting entry needed at December 31, the end of the current accounting period, for each of the following independent cases affecting Chicago Mercantile Services (CMS). Teaching Tip 2 Teaching Tip 4 a. Each Friday, CMS pays employees for the current week s work. The amount of the payroll is $2,000 for a 5-day work week. The current accounting period ends on Tuesday. The employees have not been paid for two days of work (Monday and Tuesday). Salary expense per day = $2,000/5 = $400 per day. Salary Expense must be increased (a debit) by: 2 $400 = $800 Because the employees have not yet been paid, the Salary Payable liability must also be increased (a credit) by $800. Salary Expense Salary Payable b. CMS has received notes receivable from some clients for professional services. During the current year, CMS has earned accrued interest revenue of $1,100, which will be received next year. We need to increase (a credit) Interest Revenue by $1,100. Because this interest revenue has not yet been collected, it is interest receivable (that is, Carson will receive it in the future). Interest Receivable (an asset) is increased (a debit) by $1,100. Instructor s Edition Special Section Page 17 Chapter 3

108 29366_13_03SS_p /14/07 3:41 PM Page 18 Interest Receivable Interest Revenue 1,100 1,100 Teaching Tip 2 c. The beginning balance of Supplies was $1,800. During the year CMS purchased supplies costing $12,500, and at December 31 the inventory of supplies on hand is $2,900. Supplies are an asset a future benefit. Once the supplies are used, they are a past benefit. The balance in the supplies account before adjustment is $1,800 + $12,500 = $14,300. The supplies that have been used are no longer assets, so the Supplies asset must be decreased by $14,300 $2,900 = $11,400 (a credit). Past benefits are expenses, so Supplies Expense must also be increased (a debit) by $11,400. Supplies Expense Supplies 11,400 11,400 Teaching Tip 1 Teaching Tip 4 d. CMS is conducting market research, and the client paid $20,000 at the start of the project. CMS recorded this amount as Unearned Service Revenue. The research will take several months to complete. CMS executives estimate that the company has earned three-fourths of the total fee during the current year. At December 31, three-fourths of the service revenue has been earned. Service Revenue is increased (a credit) by: $20,000 (3/4) = $15,000 The Unearned Service Revenue (a liability) is decreased (a debit) by $15,000. Unearned Service Revenue Service Revenue 15,000 15,000 Chapter 3 Instructor s Edition Special Section Page 18

109 29366_13_03SS_p /14/07 3:41 PM Page 19 e. Depreciation for the current year includes Equipment, $6,300 and Building, $3,700. Make a compound entry. The entry to record depreciation expense is always the same. It is only the number (that is, the dollar amount) in the entry that changes. We must record $6,300 + $3,700 = $10,000 of depreciation expense. Depreciation Expense Accumulated Depreciation 10,000 10,000 f. Details of Prepaid Insurance are shown in the account: Prepaid Insurance Jan. 1 Sept. 30 1,800 3,600 Teaching Tip 1 Teaching Tip 4 CMS pays the annual insurance premium on September 30 each year. At December 31, $2,800 is still prepaid. The total amount in the Prepaid Insurance account at September 30 (before adjustment) is $1,800 + $3,600 = $5,400. At December 31, $2,800 is still prepaid. This means that $5,400 - $2,800 = $2,600 of insurance has been used. Insurance Expense must be increased (a debit) and the Prepaid Insurance asset must be decreased (a credit). Insurance Expense Prepaid Insurance 2,600 2,600 Instructor s Edition Special Section Page 19 Chapter 3

110 29366_12_ch3Obj_p CHAPTER 3: CHAPTER OVERVIEW Accrual Accounting and Income The chapter begins with a discussion of accrual-basis accounting and cash-basis accounting and how events are treated differently under the two methods. The student learns why the time-period concept is important and how this concept relates to reporting accounting information. This discussion leads into an explanation of the revenue and matching principles that help the accountant know when to recognize revenues and expenses in accrual accounting. Following is an analysis of ethical issues in accrual accounting and how companies can manipulate income under the accrual basis. Next the text illustrates how the financial statements are updated through the use of adjusting entries. The three categories of the adjusting entries illustrated are: deferrals (prepaid expenses and unearned revenue), depreciation, and accruals (accrued expenses and accrued revenue). The student learns how adjusting entries are prepared and how these entries affect financial statements. After the adjusting entries are explained and illustrated, the adjusted trial balance is described. The adjusted trial balance is then used in preparation of the financial statements. At this point, a summary problem reviews adjusting entries, the adjusted trial balance, and the financial statements. The closing process is explained. The authors then show the student the various account classifications on a classified balance sheet. Different formats for the financial statements are presented. The chapter concludes with a discussion of the current ratio and the debt ratio and Decision Guidelines for using both. A final summary problem reviews closing entries, the classified balance sheet, the current ratio, and the debt ratio. LEARNING OBJECTIVES After studying Chapter 3, your students should be able to: 1. Relate accrual accounting and cash flows. 2 Apply the revenue and matching principles. 3. Adjust the accounts. 4. Prepare the financial statements. 5. Close the books. 6. Use two new ratios to evaluate a business. Chapter 3 Instructor s Edition Special Section Page 20

111 29366_12_ch3Obj_p SUGGESTED PRIORITY OF CHAPTER THREE TOPICS Category 1 Topics: MUST COVER! Cash basis versus accrual basis! Time-period concept, revenue principle, and matching principle! Adjusting entries! Preparing the financial statements! Relationships among the financial statements! Ethical issues Category 2 Topics: RECOMMENDED! Current ratio and debt ratio! Detailed classification of assets and liabilities Category 3 Topics: IF TIME PERMITS! Closing entries Instructor s Edition Special Section Page 21 Chapter 3

112 29366_12_ch3Lec_p CHAPTER 3: LECTURE OUTLINE Accrual Accounting and Income OBJECTIVE 1: Relate accrual accounting and cash flows A. In accrual-basis accounting, an accountant recognizes the impact of a business transaction as it occurs. Both cash transactions (collections from customers and paying salaries) and noncash transactions (purchase of supplies on account or providing a service on account) are recorded under the accrual basis. B. Accrual accounting is more complex and more complete than cash basis accounting. All but the smallest businesses use the accrual basis of accounting. C. In cash-basis accounting, the accountant does not record a transaction until cash is received or paid. OBJECTIVE 2: Apply the revenue and matching principles Accrual accounting is based on a conceptual framework that includes these three concepts/principles: A. The time-period concept ensures that accounting information is reported at regular intervals. Because these intervals are often different from the intervals for transactions, accounts must be updated (or adjusted) to make sure that all revenues and expenses for the accounting period have been recorded. The basic accounting period is one year. Around 60% of companies use the calendar year from January 1 to December 31. B. The revenue principle governs (1) when to record revenue and (2) the amount of the revenue that should be recorded. (See Exhibit 3-1.) 1. In most cases, revenue should be recorded when the business has delivered a completed good or service to the customer. 2. The amount of revenue recorded should be equal to the cash value of the goods or services transferred to the customer. C. The matching principle tells accountants how to measure expenses and when expenses should be recorded. (See Exhibit 3-2.) 1. When possible, expenses should be matched with the revenue that created the expense (for example, Cost of Goods Sold should be matched with Sales). 2. If there is no cause-and-effect relationship, then the expenses should be associated with a time period, such as a year. D. Accrual accounting provides some ethical challenges that cash accounting can avoid. 1. In accrual accounting, expenditures are not necessarily expensed when paid; therefore, management can exercise some discretion when recording expenses. 2. Net income and liabilities can be misstated by failing to record accrued expenses. 3. During good times, liabilities can be accrued in accounts called reserves (debit expenses or losses and credit reserves). These reserves are like grandma s cookie jar. When you fell off your bike, all your grandma had to do was draw a cookie out of her cookie jar to make you feel better. When your company stumbles in future periods, managers can debit the reserves and credit revenues and gains to make everyone feel better about the company during the tough times. 4. Accelerated revenue recognition occurs when managers just can t wait until the earning process is complete before recognizing revenue. Some ways of doing this are recording sales based on anticipated orders from customers, recording a project as completely done when it is Chapter 3 Instructor s Edition Special Section Page 22

113 29366_12_ch3Lec_p still in progress, and recording all of the revenue at the time of the delivery of the product when an obligation to service the product extends into the future. OBJECTIVE 3: Update the financial statements by adjusting the accounts A. Why are adjusting entries needed? Adjusting entries are needed to bring the books up to date for transactions that have taken place but that may not be associated with a single, economic event. They are recorded on the last day of the period. 1. Certain revenues and expenses have not been recorded by the end of the period. Adjusting entries ensure that revenues and expenses, and therefore net income, are correct. 2. The revenues and expenses referred to above also have an effect on related asset and liability accounts. Adjusting entries are needed to ensure all balance sheet accounts carry correct balances. B. There are three categories of adjusting entries. (The information presented in the unadjusted trial balance in Exhibit 3-3 will be used to prepare adjusting entries. Exhibit 3-7 shows what type of accounts should be debited and credited for each category of adjusting entries. Exhibit 3-8 shows all the adjusting entries illustrated in the chapter.) 1. A deferral is an adjustment of an asset or a liability for which the business paid or received cash in advance. 2. Depreciation records the obsolescence and/or wear-and-tear on a long-term asset. The adjustment is similar to a deferral. 3. An accrual, the opposite of a deferral, is an adjustment of an asset or a liability for which the business records an expense or revenue before paying or receiving cash. C. Prepaid expenses require adjustment because the cash is paid in one period, but the resource is not completely used until a later period. Examples include prepaid rent, prepaid insurance, and supplies. Exhibit 3-6 diagrams the timing of prepaid-type and accrual-type adjusting entries. D. Depreciation is the allocation of the cost of a plant asset to expense over its life. (Exhibits 3-4 and 3-5 show how actual companies report plant assets.) 1. When a plant asset is acquired, an asset is recorded. This asset will eventually wear out, or depreciate. Therefore, the asset is expensed as it is used. 2. As the asset depreciates, the asset value declines. Instead of reducing the asset account, or another account, Accumulated Depreciation, is used. a. Accumulated Depreciation is a contra asset account; that is, an asset account with a credit balance. b. The book value, or carrying value, of the asset is determined by deducting the accumulated depreciation from the original cost. E. Accrued expenses are expenses that are incurred by the end of the period but will not be paid until the next period. The adjusting entry records the expense and a liability. The text illustrates accrued salary expense. F. Accrued revenues are revenues that have been earned (because the good or service has been delivered) but not yet received. The adjusting entry records increases to both a revenue and a receivable. The text illustrates accrued service revenue. G. Unearned revenues arise when a business receives cash in one period but does not earn all of it until a later period. 1. An unearned revenue is a liability because the business owes the customer a good or service. 2. The adjusting entry records the part of the unearned revenue that has been earned. H. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. (Exhibit 3-9 shows the trial balance, adjustments, and the adjusted trial balance in worksheet form.) Instructor s Edition Special Section Page 23 Chapter 3

114 29366_12_ch3Lec_p OBJECTIVE 4: Prepare the financial statements A. The financial statements are prepared using the account balances found on the adjusted trial balance. (Exhibits 3-10, 3-11, and 3-12 show how adjusted trial balance information is used. B. The income statement must be prepared first. C. The statement of retained earnings is prepared next, using the net income calculated from the income statement. D. The balance sheet is prepared last and uses the ending balance of retained earnings from the statement of retained earnings. OBJECTIVE 5: Close the books A. Closing the books or accounts refers to the end-of-period process of preparing the accounts for the next accounting period. B. Closing entries perform two functions: 1. Closing entries set the balances of temporary accounts to zero. a. Temporary accounts are the revenue, expense, and dividend accounts. b. These account balances need to have a zero balance to begin the next accounting period. 2. The balances of the temporary accounts are transferred into retained earnings. 3. Permanent accounts are the accounts that will not be closed assets, liabilities, and stockholders' equity accounts. C. There are three closing entries (See Exhibit 3-13): 1. Each revenue account is debited and Retained Earnings is credited. 2. Each expense account is credited and Retained Earnings is debited. 3. Dividends are credited and Retained Earnings is debited. D. The various classifications of accounts on the balance sheet are: 1. Current assets are listed first because they are more liquid; that is, current assets can be converted into cash more quickly than other assets. a. Current assets are expected to be converted to cash, sold, or consumed during the next 12 months or within the business s normal operating cycle, whichever is longer. The operating cycle is the time it takes a business to acquire goods and services, sell these goods or services, and collect from the customers. b. The current assets are Cash, Accounts and Notes Receivable, Inventory, and Prepaid Expenses (such as Supplies, Prepaid Insurance, etc.). 2. Long-term assets are assets that are not current. Long-term assets include Property, Plant, Equipment (account titles Land, Buildings, Furniture and Fixtures, and Equipment have been used so far) and Long-Term Investments, Intangible Assets, and Other Assets. 3. Current liabilities are debts that are due to be paid within the next 12 months or within the operating cycle, whichever is longer. Accounts Payable, Notes Payable (due within one year), Salary Payable, Unearned Revenue, Income Tax Payable, and Interest Payable are examples. 4. Long-term liabilities are all liabilities that are not current. An example is Notes Payable (due after one year). Chapter 3 Instructor s Edition Special Section Page 24

115 29366_12_ch3Lec_p E. A balance sheet that uses these various classifications is called a classified balance sheet. Classified balance sheets can appear in two different formats. Exhibit 3-14 illustrates a classified balance sheet, income statement, and statement of cash flows of an actual company, Starbucks Corporation. 1. The report format shows the assets first, then liabilities beneath the assets, and the stockholders equity beneath the liabilities. 2. The account format reports the assets on the left and the liabilities and stockholders equity on the right. F. There are two basic formats for the income statement. 1. A single-step income statement lists all revenues together under one heading and all expenses together under another heading. Revenues (listed individually) Less: Expenses (listed individually) Net income $XX XX $XX 2. A multi-step income statement contains subtotals to highlight important relations between revenues and expenses. Exhibit 3-15 illustrates Starbucks Corporation s multi-step statement. Net sales revenue COGS Gross profit Operating expenses (listed individually) Income from operations Other income (expense) Income before income tax Income tax expense Net income $XX XX XX important subtotal XX XX important subtotal XX XX important subtotal XX $XX OBJECTIVE 6: Use the current ratio and debt ratio to evaluate a business A. The current ratio measures a company s ability to pay current liabilities with current assets. 1. The formula is: Current ratio = Total current assets Total current liabilities 2. A company prefers to have a high current ratio, which indicates that it should have little difficulty paying current debts as they come due. 3. A current ratio that is too high may mean that a company has too many current assets that are low-earning assets. B. The debt ratio indicates the proportion of a company s assets that is financed with debt. 1. The formula is: Debt ratio = Total liabilities Total assets 2. A low debt ratio indicates that the company has a relatively small amount of debt, which results in small interest and principal payments. C. Decision Guidelines answer many questions about using the current ratio and debt ratio. Instructor s Edition Special Section Page 25 Chapter 3

116 29366_12_ch3AG_p CHAPTER 3: ASSIGNMENT GRID Accrual Accounting and Income Assignment Topic(s) L.O. Estimated Time (minutes) S3-1 Linking accrual accounting and cash flows S3-2 Linking accrual accounting and cash flows S3-3 Applying revenue and the matching principles Level of Difficulty 1 10 Easy 1 10 Easy 2 10 Easy S3-4 Adjusting prepaid expenses 3 10 Easy S3-5 Recording depreciation; 1,3 10 Medium cash flows S3-6 Applying the matching principle and the timeperiod concept Easy S3-7 Accruing and paying 3 10 Medium interest expense S3-8 Accruing and receiving cash 3 10 Medium from interest revenue S3-9 Explaining unearned Easy revenues S3-10 Reporting prepaid expenses Easy S3-11 Adjusting the accounts 3,4 10 Easy S3-12 Preparing the financial Medium statements S3-13 Making closing entries Medium S3-14 Computing ratios 6 10 Easy S3-15 Using the current ratio and Easy the debt ratio E 3-16 Linking accrual accounting 1 Easy and cash flows E 3-17 Linking accrual accounting 1 10 Easy and cash flows E 3-18 Accrual basis versus cash basis, applying accounting principles 1, Medium E 3-19 E 3-20 E 3-21 E 3-22 Applying accounting concepts and principles Applying accounting concepts Journalizing adjusting entries and analyzing their effects on net income; accrual basis versus cash basis Allocating prepaid expense to the asset and the expense Easy Easy (Will have an X if available) Excel General Templates Ledger Templates 1, Medium X X 2, Medium X Chapter 3 Instructor s Edition Special Section Page 26

117 29366_12_ch3AG_p E 3-23 Journalizing adjusting Easy X entries E 3-24 Journalizing adjusting Medium entries E 3-25 Prepare financial statements Easy X E 3-26 Analyze adjustments 3, Medium E 3-27 Analyze adjustments 3, Medium E 3-28 Computing financial Difficult statement amounts E 3-29 Prepare closing entries Medium E 3-30 Prepare closing entries Medium E 3-31 Prepare a classified balance 4, Medium sheet and use ratios E 3-32 Effects of ratios Medium E 3-33 Adjusting the accounts, 3,4,5, Medium X preparing the financial statements, closing the accounts, and evaluating the business 6 E 3-34 Effects on the current ratio Medium E 3-35 and the debt ratio Adjusting the accounts, preparing the financial statements, closing the accounts, and evaluating the business 3,4,5, Difficult PQ 3-36 to Practice Quiz All Medium 3-52 P 3-53A Linking accrual accounting Medium and cash flows P 3-54A Cash basis versus Medium accrual basis P 3-55A Applying accounting 1, Easy principles P 3-56A Making accounting Medium adjustments P 3-57A Preparing an adjusted trial 3,4, Medium X X balance and the financial statements; using the current ratios to evaluate the business P 3-58A Analyzing and recording Medium X X adjustments P 3-59A Preparing the financial Medium X statements and using the debt ratio P 3-60A Preparing a classified 4, Difficult balance sheet and using ratios to evaluate the business P 3-61A Closing the books and Medium evaluating retained earnings P 3-62A Analyzing financial ratios Medium Instructor s Edition Special Section Page 27 Chapter 3

118 29366_12_ch3AG_p P 3-63B Linking accrual accounting Medium and cash flows P 3-64B Cash basis versus accrual Medium basis P 3-65B Applying accounting 1, Easy principles P 3-66B Making accounting Medium adjustments P 3-67B Preparing an adjusted trial 3,4, Medium X balance and the financial statements; using the current ratio to evaluate a business P 3-68B Analyzing and recording Medium adjustments P 3-69B Preparing the financial 4, Medium statements and using the debt ratio P 3-70B Preparing a classified 4, Difficult balance sheet and using ratios to evaluate the business P 3-71B Closing the books and Medium evaluating retained earnings P 3-72B Analyzing financial ratios Medium Decision 1 Adjusting and correcting the 3, Difficult amounts; computing the current ratio Decision 2 Preparing financial Medium statements; continue or close the business? Decision 3 Valuing a business on the 3, Difficult basis of its net income Decision 4 Completing the accounting 3, Difficult cycle to develop the information for a bank loan Ethical Various All Issue 1 Ethical Various All Issue 2 Focus on Pier 1 Imports All Analysis Focus on Financials: YUM! Brands Tracing account balances to the financial statements 3, Medium Chapter 3 Instructor s Edition Special Section Page 28

119 29366_12_ch3AC_p29 CHAPTER 3: AUTHOR S CHOICE Accrual Accounting and Income Suggested exercises and problems to enhance: Learning Objective 1: Relate accrual accounting and cash flows. S3-1; S3-2; S3-16; S3-17; P63B These exercises entail the relationship issues of matching accruals and cash flow. Learning Objective 2: Apply the revenue and matching principles. S3-3; S3-6; E3-20; P3-55A; P3-65B These exercises and problems provide various ways to allow the student to grasp an understanding of how the theory of taking revenue and matching it to time period allows for an easy determination of cash flow. Learning Objective 3: Adjust the accounts. S3-4; S3-7,8,9; E3-23,24; P3-56,58A; P3-66,68B. These exercises and problems allow the student to apply the principles of matching to adjust accounts that have been devalued over a time period, such as adjusting prepaid rents, supplies, insurance, etc. Learning Objective 4: Prepare the financial statements. P3-57A; P3-59A; P3-60A; P3-67B; P3-69B; P3-70B. These exercises and problems give the student added practice in completing the financial statements by using information from their adjusted trial balances. Learning Objective 5: Close the books. E 3-29,30,35; P3-61A; P3-71B. These exercises and problems allow the student to practice preparation of closing the books by writing and posting the appropriate journal entries. Learning Objective 6: Use two new ratios to evaluate a business. S3-14,15; E3-31; E3-35; P3-57A; P3-59A; P3-62A; P3-67B; P3-69B; P3-72B. These exercises and problems aid students in their ability to take financial statements and make judgments on the financial success of the business. Other: The practice quizzes in the middle of the EOC exercises and problems could be assigned to test students knowledge of accounting theory and application using a multiple-choice pattern of answers. Instructor s Edition Special Section Page 29 Chapter 3

120 29366_12_ch3Quiz_p CHAPTER 3: 10 MINUTE QUIZ Accrual Accounting and Income Name Date Section Circle the letter of the best response. 1. The Smallwood Corporation began operations on January 1, 20X5. During 20X5, Smallwood collected $92,000 for management services; $12,000 of the amount collected was from a contract to provide management services for one year beginning November 1, 20X5. An additional $20,000 of management services had been earned but not collected by year end. The amount of revenue that should be reported for 20X5 under the cash basis and accrual basis is: Cash Basis Accrual Basis A. $92,000 $80,000 B. $92,000 $102,000 C. $80,000 $100,000 D. $100,000 $112, Which of the following statements is false? A. The time-period concept requires companies to prepare financial statements at least quarterly. B. According to the revenue principle, revenue should be recorded when a product or service has been delivered to the customer. C. When possible, expenses that can be linked to a specific revenue should be deducted from revenue in the same period that the revenue is recorded. D. The time-period concept, the revenue principle, and the matching principle all support the practice of preparing adjusting entries. 3. The Armstead Company has $1,800 worth of office supplies on hand at the beginning of the year. Purchases of office supplies totaled $4,000 during the year. A year-end inventory revealed $2,100 worth of office supplies still on hand. Which of the following is the correct adjusting entry for supplies? A. Supplies 2,100 Cash 2,100 B. Supplies Expense 5,800 Supplies 5,800 C. Supplies Expense 3,700 Supplies 3,700 D. None of the above is the correct adjusting entry. 4. On November 1, 20X5, the Jernigan Company paid $4,800 for a one-year insurance policy. On December 31, 20X5, the adjusting entry would include: A. a debit to Insurance Expense, $4,800. B. a credit to Insurance Payable, $800. C. a credit to Prepaid Insurance, $800. D. a debit to Insurance Expense, $4, Which of these could not be a closing entry? A. Salary Expense XX Retained Earnings XX B. Retained Earnings XX Dividends XX C. Service Revenue XX Retained Earnings XX D. All of the above could be a closing entry.

121 29366_12_ch3Quiz_p What type of account is Unearned Revenue (asset, liability, stockholders equity, revenue, or expense) and what is its normal balance, respectively? A. Asset, debit B. Expense, debit C. Revenue, credit D. Liability, credit 7. Which of the following transactions is considered an accrued expense? I. Salaries that employees have earned but have not received II. Management fees received in advance III. Newspaper advertising that has been purchased but has not yet appeared in the newspaper A. I only C. III only B. II only D. Both I and II 8. Which of the following accounts is not considered a current asset? A. Equipment C. Inventory B. Accounts Receivable D. Prepaid Rent 9. Which of the following accounts is not considered a current liability? A. Accounts Payable B. Accrued Interest Payable C. Mortgage Payable D. Unearned Subscription Revenue 10. The balance sheet for Arnold s Cleaners appears below: Arnold s Cleaners Balance Sheet December 31, 20X5 Assets Liabilities Cash $400 Accounts payable $300 Accounts receivable 460 Salary payable 20 Supplies 10 Unearned revenue 120 Prepaid insurance 60 Note payable (due in 5 years) 400 Equipment $400 Total liabilities 840 Less: Acc. depr Stockholders Equity Land 400 Common stock 370 Retained earnings 480 Total stockholders equity 850 Total assets $1,690 Total liabilities and stockholders equity $1,690 Arnold s current ratio for 20X5 is: A B C. 2 D ANSWER KEY TO CHAPTER 3 QUIZ 1. B 2. A 3. C 4. C 5. D 6. D 7. A 8. A 9. C 10. A Instructor s Edition Special Section Page 31 Chapter 3

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